David Merkel – Page 268 – The Aleph Blog

Problems with Tax Reform

Posted on 12 April 200822 June 2017 by David Merkel

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.

The Problem with Hoarding, or, Don’t Play a Game with Someone Who Can Change the Rules

Posted on 12 April 2008 by David Merkel

US Dollar reserves continue to build up in the Middle East, China, and other parts of the world as well.? Good for them.? Isn’t it great that they have all of those foreign currency reserves to draw on?

Well, maybe. The question becomes who they sell the dollar assets to, and at what price.? When many nations hold an excess of dollar claims, more than they need for trade purposes, the desire to have more dollar claims declines.? Thus the dollar falls in value versus other currencies.? Eventually the day will come where US goods are irresistible, but we aren’t there yet.

And, we are putting out more dollar claims.? Witness the trade deficit and the record US government budget deficit (and that’s with Social Security on-budget, and the wars and other “emergencies” off-budget.? Let the rest of the world fund our spending by lending to us in depreciating dollars.

Well, that creates inflation in the US, with import price rises feeding that.? It feeds inflation in the countries that insist on keeping their currencies artificially cheap versus the dollar to subsidize their exporters.? It fees recession, or at least economic slowing. in nations that allow their currencies to rise to restrain inflation.

So, back to my title.? Hoarding US dollar reserves brings no advantage after a certain point, particularly when many are doing it.? There is nothing scarce about dollar claims.? Take the rest of the title: would you play a game with someone who can change the rules against you? Lending to the US in US Dollar terms is exactly that.? The US mouths a strong dollar policy while pursuing a weak dollar policy.? Who in the US government cares about the budget or trade deficits at present, enough to do something about them?? No one significant.? Both parties are spending like there is no tomorrow, out of a sense of financial crisis.

What will impose discipline on the system?? A falling US Dollar, and a lack of willingness for foreigners to accept payment in US Dollars.? Or, massive foreign demand to buy US companies, not debt.? Or, nations that stop subsidizing their exporters, because the inflation becomes too great, and allow their currencies to appreciate.? Maybe we see this in a few years, but certainly by 2020.

Nerds and Barbarians

Posted on 11 April 2008 by David Merkel

There have been a lot of bits and bytes spilled recently over whether hedge funds like volatility or not. Here’s a sampling:

Here’s the truth, the answer isn’t a simple yes or no.? Hedge funds are limited partnerships that do a wide variety of things in the markets.? Some aim for easily modeled consistent gains through arbitrage.? Others aim for maximum advantage, no matter what.? I call the first group the “nerds” and the second group the “barbarians.”? Neither of these terms are meant to be insulting — I consider myself to be a nerdy barbarian.

Nerds are yield-seekers.? They are attempting to achieve high smooth yields well in excess of the nominal risk-free rate on a constant basis.? They tend to get funded by fund-of-funds who attempt to diversify nerds, and maybe a barbarian or two, who have clients looking for smooth yields in excess of their hurdle rates.

When volatility rises, nerds get hurt.? In the same way that junk bond investors get hurt in volatile times, so do hedge fund nerds.? Almost all simple arbitrages rely on calm markets, where there is enough liquidity to finance every project imaginable, and a few that aren’t imaginable.? Volatility alerts investors to the concept that maybe there will not be enough cash flow to complete the transaction at a positive net present value.

Barbarians are another matter.? They swing for the fences, and are looking for maximum advantage.? They look to earn the returns from big bets that could be right or wrong.? They like increased volatility, because it enables them to take positions when they are despised or enraptured.? They play for the mean reversion, something that the nerds can’t do.

To make matters more complex, some hedge fund groups blend the two attitudes.? Good idea, if you can maintain your competitive advantages.

To close this, there is no simple answer to whether hedge funds like volatility or not.? Some benefit,? some get hurt. In my opinion, because of hedge fund-of-funds, which like nerds, volatility tends to hurt hedge funds in aggregate, but not by much.

With credit spreads wide, and disarray among the nerds, it is probably time to favor high yield investing and nerds in hedge funds.??? Don’t jump in with both feet though, I would only allocate 50% of a full position at present.? There is a lot more volatility to be worked out of the system.

The Global View — Six Themes

Posted on 10 April 2008 by David Merkel

Though I write mainly about US economic and investment issues, I try to be think globally as I consider macroeconomics. I think that many economists are hobbled because they think about the US economy in a closed framework, neglecting the effects that the rest of the world has on the US. Prior to the end of the cold war, that was a useful shortcut, but now many aspects of the US economy depend on global, and less on local factors. (Some articles cited here will be dated, but are still relevant in my mind.)

This article is meant to take you through six themes affecting the global economy. Here goes:

China

I’ve been writing about neomercantilism and China now for almost five years. The negative effects are now obvious. Inflation has been rising in China, because too much credit is chasing too few goods. That inflation is funneling into US goods prices as well. China exports too much, and imports too little, which forces them to import US credit. This is getting tired, and the Chinese and Middle Eastern savings gluts need a new place to invest, or better, new goods to buy. Absent these adjustments, in order to cool the economy, the PBOC keeps raising reserve requirements again and again. Better they should revalue the yuan up 20%, or they will continue to import inflation from the US.

China has its growing pains amid this. Pollution is rampant, and standards for product safety are low. Beyond that, China now competes with the US and Europe for economic alliances in Africa. Given past bad blood there, the Chinese may at many points be better received, that is, until they abuse their welcome.

Currencies

The main question here is the demise of “Bretton Woods II” where the rest of the world uses the US Dollar as the main reserve currency, while the US continues to debase the dollar through the issuance of more dollar claims. You can read about it in any of the following articles:

The end of the United States exorbitant privilege?
Imbalancing act
Has the moment come to replace the US dollar?
Jim Rogers: More Pain for the Greenback, and the Failure of the Federal Reserve (Now, I would argue with Jimmy Rogers over a number of his facts, but he has the main thrust correct.)

Now, Ken Fisher told us not to worry about the declining dollar, but the euro-yen exchange rate. It’s too early to say, but that exchange rate is flat, while the S&P 500 is off 7% or so. Perhaps the overall carry trade is weakening, but not with the euro as a currency to purchase, yet.

Finally, not only is the weak dollar good for exports, but for tourism as well. Now maybe they buy some of our slack houses as well…. please?

Inflation, Especially Food Prices

All the buzz is over rice, which has risen fivefold in six years. You can read about it here:

Now, that inflation is feeding back to the US, but slowly.? You would think that this would be a great time to eliminate US farm subsidies, but no, they are too effective at ~~buying votes~~ insuring economic stability in the Midwest.

Now, in the face of these inflationary pressures, the ECB is not mimicking the Fed.? They see the inflationary pressures, and aren’t loosening, at least not much.? Australia is even tightening.

Recession Fears in the Developed World

Now there are similar stresses in housing in some places of Europe, as compared to the US.? Consider Spain (and here), and the UK.? Low-ish interest rates can lead to overbuilding anywhere, if the regulators look the other way.? Japan may not have housing worries, but their growth is slowing, and they worry about the next recessionary leg of a what is proving to be a long recessionary era (since 1990).

Energy

It doesn’t matter how you slice it, Chavez has mismanaged the Venezuelan economy, and particularly the oil industry.? Now he is trying to do the same thing to cement.? Venezuelans are experiencing shortages and high inflation, as Chavez directs resources that he has ~~stolen~~ nationalized to his cronies and his foreign interests that he funds in order to make life difficult for US foreign policy in Latin America (not that I am a great fan of US policy there — I only recognize the conflict).

The Middle East has lots of new oil fields to tap at the right price, yes?? Well, I’m not so sure.? It is interesting to see the UAE develop a nuclear program.? Perhaps they are looking to a day when oil will not be so plentiful?? Then again, maybe we will have a big energy find in Greenland (an island that may once again be green, now that temperatures are rising to levels last seen in the middle ages).

Emerging Markets

Coming back to the beginning of the article, emerging markets (like China), are going through an adjustment period.? Since these two articles were written, emerging market equities have fallen significantly.? They may fall further; many of those nations are geared to global growth, and when it slows, it slows even more for them.? Many of them are absorbing US inflation as well, and need to raise their exchange rates.? That will hurt exports in the short run, but will aid in bringing economic stability.

Industry Ranks April 2008

Posted on 9 April 200810 April 2008 by David Merkel

Okay, here are my industry ranks for April 2008. Please remember that my model can be used in value mode (the green zone) or in momentum mode (the red zone). I usually just stick to the green zone, but this time I included a few red zone ideas. So, this time I added in technology companies, insurance, industrial and healthcare companies. Yeah, I know that’s a lot, and my results reflected that — usually I have just 20 or so companies from the screen, but this time it is 80+.

Oh, my screen, aside from industry, has only two factors: market cap greater than $100 million, and Price-to-book times Price-to-forward earnings must be less than 10. Ben Graham had a similar criterion, except that he used trailing P/E, and his cutoff was 22.5. Here are the tickers:

ABG ACGL ACMR ACW ADPI AEL AFFM AGYS AHL AIG AMSF ARM AWH AXS BBW BC BRLC BRNC CBR CHUX CLS CMOS CNA CVGI DK EDS ENH ENSG FFG FL FLEX FMR FRPT GPI HMX HOTT HTRN IKN INDM IPCR IRF KEM KG LAD LNY LTR MENT MIG MRH MRT MWA MXGL NCS NNBR NSIT NSTC NYM OCR ODP PCCC PDFS PKOH PLAB PMACA PNX PRE PSS PTP RE RMIX RNR ROCK RTEC SAF SAH SANM SEAB SMP SNX TECUA THG TRS TRW TRX UAM UNM XL XRIT

Lots of insurers — what can I say, the group is cheap… cheaper than the lack of pricing power should make them. Add in two more tickers that crossed my desk today: MRO and AWI, and I think I am ready to put my spreadsheet together and start analyzing promising cheap companies. One nice thing about my methods is that it can accommodate a large number of tickers. When you add up the tickers from yesterday and today, and add in the 32 existing tickers, that’s almost 300 tickers altogether.

Fortunately, my ranking system helps my winnow down the list pretty quickly, as it scores cheapness on a wide number of variables at once, and throws in many of the anomalies that are mispriced in the markets. Then it is up to me to use business judgment to decide what makes sense, because most cheap stocks are cheap for a reason, while the gems are merely overlooked.

Feel free to pitch in more stock ideas. I should come to decisions within a week or so.

PS — Have you checked out Newsflashr.com yet? It looks like a promising way of aggregating financial news, as well as other news.

The Financings of Last Resort

Posted on 9 April 2008 by David Merkel

After seeing the amazing “refinancings” done by entities like MBIA, Thornburg, WaMu, and Rescap, I felt it was right to comment on last-ditch financing methods, so that you can recognize desperation (if it’s not obvious already).? Here are some methods:

Borrow money using a healthy subsidiary while limiting capital flows up to the less than healthy holding company (e.g., MBIA) .
Do a rights offering at a significant discount, diluting existing shareholders if they don’t participate.
Offer common stock at a significant discount to a private buyer (perhaps with warrants), diluting existing shareholders, but perhaps allowing the company a chance to play again another day. (e.g. WaMu, Thornburg).
Offer a convertible bond/preferred to monetize the volatility of the stock price, contingently diluting existing shareholders. (e.g. Lehman, Citigroup, Merrill)

With the exception of the first one, all of these dilute existing shareholders, usually driving the stock price down in the short run, unless the removal of fear of bankruptcy is the dominant factor.? With the first one, it is an example of structurally subordinating lenders to the holding company, who now lose “first dibs” on the value of the healthy subsidiary.

I try to avoid companies that do financings like these, or are likely to do them.? They have a high default rate.? And what goes for the stock here, goes triple for the corporate bonds, where you have all of the downside of the stock, and little of the upside, if the company should manage to survive.

Beginning of the Second Quarter Portfolio Reshaping

Posted on 8 April 20088 April 2008 by David Merkel

Well, it’s that time again. Time to make a few portfolio swaps. At present I have two placeholder securities, the industrial Spider, and the technology Spider. Those will go, and I may sell one more security, but that’s it. I will use the proceeds to buy 2-4 positions, so that I will end with 34-35 positions.

When I run across an idea between quarters, I write it down on a sheet and wait for the next reshaping. Well, here is the list of tickers I came across over the last 3 months:

AAUK ACE ADI ADPT ADSK ALB ALL ALV AMAT AMGN AMH AN ANDS APD ARG ASH AW AZN BA BDK BGC BNI BRCD BTU CAG CB CC CCI CHRS CIU CLNE CNQ CONN CPB CRC CRI CSCO CSE CSX CTHR CVG CVI DEO DITC DKS DNR DRI EMC EQ ETFC ETP FMX FRX FSII FTD GDI GIII GT GTI GTS HAR HBOOY HCC HD HOC HTCH HTH HUM IBM INFS ISLN ITRN JBL JCI JCP JRT JTX KFS KMP KMX KOP KR KSS LAMR LDIS LM LOW LXK MAS MCHP MMP MNKD MSN MTA MTW MYE NII NSC NTGR NTT NUHC OMX ORCL OVTI OXY PARL PAYX PBR PCZ PERY PHH PMRY POM PTEN PVX PX QTM RAI RDC RDS RELL RES RHD RJF ROST RSC S SCSS SCX SHW SIRF SNDK SNY SPIL STX STZ SU SUN SUR SVU T TBAC TDW TGT TM TOT TRV TSN TSO TXN TXT TZOO UNP UPRT URBN VMW VOXX VZ WAG WC WDC WHR WIN WLP WNR WPC WTM XRX YUM ZURNY

One of the fun parts of this exercise is that I invite readers to submit their own ideas as well. Feel free to leave them in the comments below.

From here, I will update my industry model, run some screens, and post additional tickers. After that, I will compare the replacement candidates against my existing portfolio, using my multifactor appoach. I will keep you apprised of my thoughts as I move toward making the portfolio changes.

Full disclosure: long XLI XLK

Fourteen Notes on Monetary Policy

Posted on 8 April 2008 by David Merkel

This post is on current monetary policy. The review piece on how monetary policy works is yet to come.

1) Let’s start out with the regulatory issues to get them out of the way, beginning with Bear Stearns. To me, the most significant thing to come out of the “rescue” was the Federalizing of losses from the loans that were guaranteed by the Fed (something which I noted before had to be true, since the Fed turns over its profits to the Treasury), and the waiving of many leverage rules for the combined entity (also here and here). These in turn led to an attitude that if the Fed was going to lend to Bear (however indirectly), then they should be regulated by the Fed.

Now, I don’t blame the Fed for bailing out Bear, because they were “too interlinked to fail.” You could say, “Too big to fail,” but only if you measure big by the size of the derivatives book. The last thing that the investment banks needed was a worry on concentrated counterparty risk affecting the value of their derivative books.

That said, given that Jamie Dimon was very reluctant to help unless the Fed provided guarantees, and the low price paid, it indicates to me that Bear and the Fed were desperate to get a deal done. What was in it for Bear? I’m not sure, but the deal avoided greater ignominy for the board, and might preserve jobs at Bear for a longer period of time.

2) At a time like this, many cry for tighter regulation in the the intermediate-term and more aggressive actions in the short-term to restore liquidity. Forget that the two of these fight each other. Personally, I find the comments from the IMF amusing because they are an institution in search of a mission; the IMF was designed to help developing nations, not developed ones. The comments from the FDIC Chairwoman are good, but really, where were the banking regulators in 2005-2006, when something useful could have been done?

3) Does the Fed want to be a broader financial regulator? My initial guess would be “no,” but I could be wrong here. Part of my reasoning is that they have not used the powers effectively that they already have. Another part is that monetary policy has often been misused, and been pro-cyclical. With their new powers, they will still face significant noise and data lags. Why should they be more successful at a more complex task than they have been with the less complex task of monetary policy? Schiller is way too optimistic here. The central bankers are part of the problem here, not part of the solution. For years they provided too much liquidity in an effort to keep severe recessions from occurring, and in the process they removed fear from the financial system, and too much leverage and bad underwriting built up. Now the piper has to be paid.

4) Eric Rosengren, president of the Federal Reserve Bank of Boston, comments on the difficulties involved in effective regulation of financial institutions as a lender of last resort.? The Fed will have to build new models, and think in new paradigms.

5)? Charles Plosser, President of the Philadelphia Fed, tells us not to overestimate monetary policy.? Sage words, and rarely heard from the Fed (though in my experience, more often heard toward the end of a loosening cycle).? Plosser moves up a couple of notches in my view… monetary policy can deal with price inflation, and that’s about it.? Once we try to do more than that, the odds of making a mistake are significant.

6)? Who loses when the Fed loosens?? Savers.? They earn less; there is a net transfer of wealth from savers to borrowers.? Holders of US-dollar based fixed income assets also bear the brunt, if thy have to convert it back to their harder currency.

7)? Perhaps the TSLF is succeeding.

8 ) But perhaps all of the Fed’s efforts on the asset side are making it more difficult for Fed to keep the fed funds market stable.? I have one more graph that stems from my recent piece on the Fed:

Note that during the past six months, the low transaction on Fed funds was significantly below the effective rate.

9) VIX and More has latched onto this calculation of M3.? Given the changes and the adjustments that they have made, and the 20% or so rate of growth for M3, I would want to see a “spill” of the calculation to see what’s going on.? Perhaps there has been some double-counting.

Now, if we are talking about MZM (all monetary liabilities immediately redeemable at par) , we are facing high rates of growth — around 17% YOY.

My M3 proxy, total bank liabilities, is running ahead at a 13%+ rate.? Only the monetary base stays in the mud with barely 2% growth.? I still think that the Fed is trying to restrain inflation through no monetary base growth, while allowing the healthy banks to grow aggressively.? So much for supervision.

10)? Reading the H.4.1 report the past weeks have had the Fed lending more directly through their new programs, and selling Treasuries to keep the Fed’s balance sheet from growing.

11) I expect the minutes tomorrow to reveal little that is new; if anything, it will highlight the competing pressures that the Fed is trying to deal with.

12) For a view compatible with mine, read Bob Rodriguez of First Pacific Advisors.? One of my favorite equity managers, and he is doing well in the present environment.

13) The yield curve and Fed funds futures indicate another 25-50 basis points of easing in this cycle, at least, until the next institution blows up.

14) Finally, and just for fun — two guys I would nominate for the Federal Reserve Board — Ron Paul and James Grant.? Toss in Steven Hanke, and it starts to get interesting.

Broker Solvency as a Marketing Tool

Posted on 7 April 20087 April 2008 by David Merkel

I received this in the mail on Saturday:

ABC logo

March 31, 2008

Dear Investor,

I am writing to tell you that my firm is in very good financial condition. Normal market conditions would not require this correspondence. But I understand that many people are deeply concerned about the stability of their brokers at this time.

I have always tried to earn my clients? trust by running the firm conservatively, with clients? interests in mind. Today, 75% of the Company?s assets are in cash or cash equivalents and we have no debt. In addition, we have no investments in collateralized debt obligations or similar instruments. As a matter of policy, we do not carry positions or make markets.

Throughout the years, in making decisions about my business, I have always put the safety of my clients? assets first. This is one of the primary reasons my firm clears on a fully disclosed basis through DEF LLC (DEF), a GHI company. DEF clears our clients? trades and is in custody of their accounts. Their name appears with ours on monthly statements and confirmations. As of December 31, 2007, DEF had net capital in excess of $2.1 billion which exceeded its minimum net capital requirement by more than $1.9 billion.

In addition, when you do business at ABC, your account receives coverage from the Securities Investment Protection Corp. (SIPC) as primary protection for up to $500,000, including a limitation of $100,000 for cash. SIPC coverage is required of all registered broker-dealers. Since most ?cash equivalent? money market mutual funds are considered securities under SIPC, investments in money market mutual funds held in a brokerage account are protected by SIPC along with your other securities to a maximum of $500,000. Of course, there is no protection that will cover you for a decline in the market value of your securities. You may visit www.sipc.org to learn more about SIPC protection.

Furthermore, DEF has arranged for additional protection for cash and covered securities to supplement its SIPC coverage. This additional protection is provided under a surety bond issued by the Customer Asset Protection Company (CAPCO), a licensed Vermont insurer with an A+ financial strength rating from Standard and Poor?s. DEF?s excess-SIPC protection covers total account net equity for cash and securities in excess of the amounts covered by SIPC, for accounts of broker-dealers which clear through DEF. There is no specific dollar limit to the protection that CAPCO provides on customer accounts held at DEF. This provides ABC clients the highest level of account protection available in the brokerage industry to the total net equity with no limit for the amount of cash or securities. And, unlike many other brokers, there is no ?cap? on the aggregate amount of coverage for all of our customers? assets. You may access a CAPCO brochure about ?Total Net? Equity Protection? at ABC.com [deleted]?.

If you are concerned about the status of your assets at another brokerage firm, you might consider moving them to ABC. It is easy to transfer assets. If you have friends who are concerned about their brokers, you might consider referring them to us. We continue to offer free trades for asset transfer and referrals. If you have questions about anything in this letter, please feel free to call us at 800-xxx-xxxx from 7:30 a.m. –7:30 p.m. ET, Monday-Friday. Once again, thank you for your trust and your loyalty.

Sincerely,

President and Chief Executive Officer of ABC

I used to do business with ABC, and I presently do business with GHI. Both of them are good firms, doing business on a fair basis for their clients. To me, it is interesting to use financial strength as a marketing tool.

On another level, how many people actually check the solvency of their brokers before doing business with them? On a retail level very few, if any. On an institutional level, that’s a normal check for sophisticated investors.

That said, I would be surprised to see any major retail brokers go insolvent aside from those with significant investment banking exposure. Even there, accounts are segregated, and client cash typically has the option of being in a money market fund.

This is not something that I worry about in investing, but if I were worried about my broker, I would make sure that my liquid assets over $100,000 were in a non-commingled vehicle, most likely a money market fund.

What of Excess Insurance?

Now, I will add just one more note in closing. CAPCO is a nice idea, but I am always skeptical of small-ish insurers backing large liabilities with a remote possibility of incidence. There aren’t that many AAA reinsurers out there, and I am guessing that Berky is not one of them. Buffett does not like to reinsure financial risks, aside from municipal debt. That leaves the AAA financial guarantors — Ambac, MBIA, Assured Guaranty, and FSA (though I am open to a surprise here). I’m guessing it’s the first two, and not the last two. CAPCO is owned by many of the major brokers, but in a crisis, CAPCO has no recourse to its owners, but only to its reinsurers, should that coverage be triggered. The recent financial troubles have led S&P to place CAPCO on negative outlook, mainly because:

Standard & Poor’s assigns a negative outlook when we believe the probability of a downgrade within the next two years is at least 30%. The revised outlook reflects the challenging environment for broker/dealers and their parents. Deterioration in their credit quality and risk-management capabilities could affect CAPCO’s financial strength. In the past couple of months, Standard & Poor’s has revised the outlook on several of CAPCO’s members’ parents to negative. Also, the ratings on a couple of members are on CreditWatch with negative implications, which means there’s the potential for a more imminent downgrade. The capital of CAPCO’s members and–in some cases–their parents is an important resource for mitigating CAPCO’s potential payments for its excess SIPC (Securities Investors Protection Corp.) coverage.

It would be interesting to know for certain the underwriters and terms of CAPCO’s reinsurance. I’m not losing any sleep over it, though… there are bigger things to worry about, my personal broker is well-capitalized, and I have less than $100K at risk in cash, and that is in a money market fund. So long as accounts remain segregated, risks are small.

Uptight on Uptick

Posted on 5 April 20086 April 2008 by David Merkel

There have been many writing about the impact of the lack of an uptick rule in the present market.? In the past, before a player could sell short, the stock had to trade up from the last trade — an uptick.? This made it hard to short a stock too heavily, forcing the price down.

Well, maybe.? I still think shorting is a pretty tough business.? First, the long community is much larger than the short community.? Second, the longs can always move their positions to the cash account if they don’t like other players borrowing their shares.? (Move to the cash account, squeeze the shorts.? Wait.? You don’t want to lose the securities lending income?? Shame on you; you should put client interests first.)

The thing is the uptick rule is not the real problem.? The real problem is that shorts don’t have to get a positive locate at the time of the shorting; a mere indication from the broker enables the short for a few weeks, while search for loanable shares goes on. This is a computerized era.? There is no reason why there can’t be real-time data on loanable shares.

There is a second problem, and less so with stocks, than with other financial instruments that are borrowed.? There needs to be stricter rules/penalties on what happens when a party fails to deliver a security.? As it is, when the cost of failing to deliver is miniscule, it can really bollix up the markets.

The longs have adequate tools to fight the uptick rule; they don’t have adequate tools to help against naked shorting and failures to deliver.