Ethics – The Aleph Blog

When Should the New Yew York Department of Financial Services have Rehabilitated American Transit Insurance?

Posted on 9 September 2024 by David Merkel

Hey! Maybe we can grow our way out of the problem! || All images from Aleph Blog

At one point in time, I was a Fellow in the Society of Actuaries, a Life Actuary specializing in investment issues. Eventually, I was hired by a hedge fund to analyze all types of insurance stocks. I knew some things about reserving outside of life insurance, but I had to learn more to become competent at understanding what made for good insurance stocks.

I learned that good P&C management teams state their financials conservatively, and aim for adequate margins over growth. They set reserves for the current year’s business high (conservative), so that in most cases reserves for business from prior years produce slight gains over time as the claims come in at less than the reserves.

I wrote an article about this back in 2014, Ranking P&C Reserving Conservatism. When I went back and looked at it after 3 years or so, those that had to strengthen reserves for prior year business did worse than those that could release their reserves for prior year business. Never published a second article on this, though.

Today I’m going to tell you about the worst P&C reserves I have ever seen, and tell you the story of how this came about. American Transit Insurance over the last few decades was the largest insurer of hired vehicles (taxis, black sedans, Uber, livery, and rideshare vehicles) in New York City. They gained a dominant market share by underpricing their insurance, and under-reserving. While market returns were high, that covered all or part of the underwriting losses.

ATI has been shaky for a long while. From this story at Insurance Journal:

“DFS said regulators made significant efforts to address ATIC’s financial problems, including filing multiple petitions to put the company into liquidation, starting back in 1979. The New York State Supreme Court denied that petition, a decision that was upheld by the Appellate Division and the State Court of Appeals in the 1980s, DFS said.”

Update: NYC’s Largest Cab Insurer Ordered to Explore Sale After Losses

And this story: “While ATIC is required by the state’s DFS to submit to an examination every five years, there are no publicly available exam reports for the company. A 1986 DFS evaluation obtained by Bloomberg described ATIC as insolvent by $6 million.”
New York City’s Biggest Taxi Insurer Is Insolvent, Risking Transit Meltdown

As a result, they raised $6.6 million of capital and continued in business. When the next five-year exam rolled around, NYDFS tried to take ATI into rehabilitation, but lost in the courts. From the first article:

“In 1991, the Insurance Department again tried to put the company into rehabilitation, prompting ATIC to seek an injunction to halt the proceeding. Ultimately, a special referee assigned to arbitrate the case suggested ATIC seek a capital infusion. A year later, the company and the state reached a settlement that allowed ATIC to remain in business, but stipulated the company keep surplus contributions and submit to enhanced state monitoring, DFS said.”
Update: NYC’s Largest Cab Insurer Ordered to Explore Sale After Losses

Now for my graphs and efforts: I downloaded the Statutory Statements for 2023, 2018, and 2013. That enabled me to look at the Five-Year Historical Data Pages, which gave me data series on important aspects of ATI’s business from 2009-2023. If you look at the graph at the top of this article, you will see how surplus declined 2009-2013. Incurred losses and loss adjustment expenses [LAE] were higher than earned premiums, and that didn’t take into account underwriting, marketing, management, and other expenses.

Their consulting actuary said in her 2013 review: “In my opinion, based on the information available for my review, the stated reserve amount does not make a reasonable provision for the liabilities associated with the specified reserves. It is my opinion that the $47,100,000 net reserves for losses and loss adjustment expenses are deficient by approximately $31,000,000. It is my opinion that the $47,100,000 direct reserves for losses and loss adjustment expenses are deficient by approximately $31,000,000. Additional information or further changes in such items as the claim handling procedures could change my estimate of the deficiency.” The surplus of ATI was a little less than $31 million. ATI was insolvent. This information was available to the NYDFS. This was the last moment to rehabilitate ATI without taking significant losses.

ATI chose to ignore the consulting actuary, and did two things. First they rolled the dice and likely said, “Let’s grow our way out of the problem!” And so they doubled their underwriting over the next five years. (See graph above.) The second thing they did was lower reserving on new business. (See graph below.) From 2009-2013, the implied expected loss plus LAE rate for new business was 81.2%. Now they had never once achieved that rate in that era. They were under-reserving new business. But from 2014-2018, they dropped that rate to 60.7%. That allowed them to report statutory profits, and growing surplus (look at the top graph). This came at a price of under-reserving even more. Looking at the graph immediately above, losses from prior year business doubled 2014-2018.

In 2018, the company again ignored their consulting actuary. In their 2018 MD&A, they said: “The Company has rejected the reports for December 31, 2018 and 2017 from its independent actuary. The actuary has estimated that the Company’s reserves for unpaid losses and loss adjustment expenses as of December 31. 2018 and 2017 were understated by approximately $45,000,000 and $36,000,000, respectively, on its filed statutory financial statements after taking into account anticipated salvage and subrogation and anticipated investment income. No such adjustments have been reflected in the accompanying financial statements since the Company has rejected the reports.”

The consulting actuary definitely underestimated the amount of under-reserving, but at least she was consistent in telling the company that they were under-reserving.

2019-2023 was the last gamble for ATI, again akin to a Ponzi, where you rob the future to pay the present. They lowered the implied expected loss plus LAE rate for new business to 27.6%. No P&C insurance company has a loss rate that low. As such the under-reserving continued to build.

We compare company surplus to the authorized control level of risk-based capital. When the ratio gets below 100%, the insurance department can seize the company for rehabilitation. So, in early 2024, NYDFS could seize it. They have not done so, and ATI, finally listening to the successor consulting actuary (to the one in 2013, 2018 etc.) announced a $700 million loss for the second quarter of 2024. The jig is up.

Note: my “true” surplus figure above assumed a 95.8% loss and LAE ratio, which was the average 2009-2023, and said the deficit is the difference between that and the implied new business loss ratio times earned premiums. Now at the end, all underwriting was out of control, and so that ratio had to be a lot higher than 95.8%. But the graph above shows directionally how bad things were going, which could not be seen by the regulatory surplus vs ACL RBC ratio calculation.

NYDFS has told ATI to find a buyer. I can tell you they will not be able to sell the joint until after the guaranty association covers the claims that ATI cannot cover. I don’t think there is any franchise value in ATI, as their only selling point was an overly cheap premium that could not cover losses, much less generate a profit. They will go into liquidation, and other insurance companies writing auto business in New York will have to cover the tab. (You have my sympathies. I lost one year of profit when I was surcharged for the losses of Confederation Life to cover their group annuity losses. Adding insult to injury, the failure of Confederation, indirectly kicked me out of the GIC business, as credit rating standards rose, and my company could not meet it. That said, it freed me to do three projects that added 5% to the surplus of the company.)

On the bright side, the CEO, Director and 3 former directors own 56% of the equity, and it will go out at zero. They may face various lawsuits from creditors not covered by the guaranty association. Perhaps the no-name auditor may also face some lawsuits. They earned a lot of fees, but did they hire a consulting actuary to validate the reserves? Did they talk to ATI’s consulting actuaries?

This brings up one final point: ignoring actuaries. In the life insurance business, management teams can’t push around their appointed actuaries (at least not much). Why do P&C management teams get to ignore their actuaries? Actuaries are bright, and they have an ethics code that they have to follow. P&C management teams should have to have actuaries that set the reserves, and they can do nothing about it.

Now I’m not going to tell you that I am a genius, all of the figures presented here are “spit-in-the-wind” estimates, and I know a trained FCAS (Fellow in the Casualty Actuarial Society) could do a lot better than me. But these estimates could be done easily at any State Insurance department with ease, as they take just seven variables from the Five-Year Historical Data Pages, and can flag reserving problems easily. NYDFS did not do what it took me three hours to do. This could have been caught in 2013 or earlier. The evidence was there.

Decentralized Ponzi

Posted on 30 January 2021 by David Merkel

Photo Credits:�Jared Enos, Stephan Mosel�&�Pine Tools�|| Ponzi would have appreciated the cleverness of wallstreetbets

The operation of the “bull pool” at wallstreetbets resembles a Ponzi scheme. There are five things that make it different:

It is decentralized.
Because it is decentralized, there is no single party that controls it and rakes off some of the money for himself, at least not directly.
The assets can be freely sold in a somewhat liquid, but chaotic market. Most Ponzi schemes have time barriers for redemption.
They caught a situation where shorting was so rampant, that triggering a squeeze was easy. Situations where the shorts are so crowded are rare.
Gamestop [GME] and other companies whose stock prices get manipulated above their intrinsic value can take the opportunity to sell more shares, as can less than 10% holders of the holders of the stock, and even the greater than 10% holders once six months have passed since their last purchase.

You have to give wallstreetbets credit for one thing, and only one thing: wiping out the shorts. It was an incredibly crowded short, and they identified an easy squeeze. But now it is harder to short, margin requirements have been tightened for both longs and shorts, given the market volatility, and even more so for options. That not only applies to individuals but to brokerages, because with the volatility, there is a greater probability of settlement failure, and broker failure. Robinhood faced possible failure and raised capital. What shorts remain are better financed than previously. When volatility goes up, so must the capital of intermediaries, including brokerages.

Ponzi schemes typically need ever-increasing flows of money to satisfy the cash need from the money being raked off. But there is no sponsor here, so what plays the role of the rake? I can think of three rakes for the money:

Most fundamentally driven longs have sold. Notable among them is MUST Asset Management of South Korea.
Some companies like AMC Entertainment and American Airlines are issuing new shares to take advantage of the artificially high price. Maybe GME will do it next week.
And, those who are more intelligent at wallstreetbets know that GME is overvalued, and have booked their gains. This is definitely a place where the old Wall Street maxim applies: “Can’t go broke taking a profit.” or “Bulls can make money, Bears can make money, but Hogs get slaughtered.” (The Hogs in this situation are the ones who buy and hold GME. Buy-and-hold only works for undervalued assets.)

Now, the grand change that has happened in the last two months is that the investor base of GME has shifted from being fundamental investors to momentum investors. There may be more institutional money pushing GME than is commonly understood. That said, institutional momentum longs tend to react quickly and sell when momentum fails, which makes matters even more volatile. They have more of a risk control discipline than na�ve retail investors do.

This is similar to what happens with promoted penny stocks. Fundamentals seem not to matter, just the amount of money thrown at the stock. There is the pump; there is the dump. The amounts of money are bigger here. We have only seen the pump. The dump is coming. And penny stocks almost always lose.

There is no magic in markets — stock prices eventually revert to intrinsic value — it is only a question of how and when. Buyers can force a stock price above intrinsic value for a little while, but eventually the price will sag back, and the only winners will be those who sold stock to them.

When I was younger, I made a mistake with a microcap stock, and placed a market order to initiate a position. (Accident: I typically only use limit orders.) The stock was so thinly traded that I got filled at levels an average of 50% above where the bid was. The price promptly fell back to where it was prior to my purchase.� This is what will likely happen with GME, and other situations like it. Mere trading can’t permanently raise the price of an asset.

One last note: those at wallstreetbets and places life it should be careful. If you are communicating with other investors about a stock and you make money as a result of the communication, you may face legal troubles if that is deemed market manipulation. And, given that you have communicated it over the internet, that could be deemed “wire fraud.” This is the nature of a government with vague laws that likes to say “gotcha” when they deem something unsavory as illegal.

Do I think it should be illegal? No. Is it unethical? Certainly. No one should promote anything like a Ponzi scheme. But in US culture now, unethical and illegal get confused, and the ideas of “mail fraud,” “wire fraud,” etc., can be applied to unethical actions that may not strictly be illegal. Such logic has been applied to promoted penny stocks, with significant wins against the promoters.

So, to those at wallstreetbets, I would say that you are living on borrowed time. This isn’t going to work, and you and those that follow you will lose money, whether the government comes after you or not. Just as the Hunts tried to corner the silver market, and failed miserably as people sold their silver sets, and miners mined like crazy, in the same way pushing stock prices too high will only lead to dilution from the corporations, and losses to the buyers who came in late., if not the early ones as well.

Look out below.

The Rules, Part LXVI

Posted on 9 May 202010 May 2020 by David Merkel

Photo Credit: Heather R || Round and round it goes, where it stops, nobody knows

Don’t bet the firm.
Attributed to the best boss I ever had, Mike Cioffi. I learned so much from him.

I was surprised to see how many times I mentioned at this blog how I considered and dropped the idea of writing floating rate Guaranteed Investment Contracts [GICs]. A lot of effort went into that decision, and unlike most decisions like that, the failures of competitors with a different view happened quite rapidly.

Also, this blog highlighted those that wrote terminable floating rate GICs later, and insurers that wrote contracts that had clauses allowing for termination upon ratings downgrades.

But that’s my own story. What of others?

The best recent example that I can give is oil producers both in 2015-6 and today. When oil prices plunged, many smaller marginal oil producers went broke. Why didn’t they take a more cautious view of their industry, and run with stronger balance sheets that could endure low crude oil prices for two years?

If you are managing for the price of your stock, maximizing the return on equity is a basic goal for many. That means shrinking your equity capital base, and living with the risk that your company could go broke with many others if the price of crude oil drops significantly. Of course, you could try to hedge your production, but at the risk of capping your returns.

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The main idea here is to have a strategy where you stay in the game. This means running with a thicker balance sheet, and hedging material risks. What stands in the way of doing that?

Having a thicker balance sheet might give a firm a lower valuation, and attract activists that will attempt to buy up the firm, partially using the excess capital that aided safety. The antidote to this is to actively sell shareholders on the idea that the firm is doing this to preserve the firm from the risk of failure, much as Berkshire Hathaway keeps excess assets around for reasons of avoiding risk and allowing for the possibility of gaining significant returns in a crisis.

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If you work for a single firm, most would say, “Of course! Don’t bet the firm! What, are you nuts!?”

But incentives matter. Where there are bonuses based on sales growth, sales will happen, regardless of the quality of them. Where there are bonuses based off of asset returns over a short period, you will have managers swinging for the fences. Where there are annual profit goals, there may be aggressive accounting and aggressive sales practices. But who cares about next year, much less the distant future? Who cares for the long-term interests of all who are affected by the firm?

Corporate culture matters. Excellent corporate cultures balance the short- and long-runs. They strive for excellent results while protecting against the worst scenarios. If the firm is able to survive, it can potentially do great things. Not so for the firm that dies.

To that end, incentives should be balanced. Those that play offense, like salesmen, should have a realized profitability component to their bonus. Investment departments should be judged on safety as well as returns. Conversely, defensive areas need to have some of their bonuses based on profits, and profit growth. It’s good to get all of a firm onto the same page nd be moderate, prudent risk-takers.

In closing, the main point here is that there is no reward so large that it is worth risking the future of the firm. Take moderate and prudent risks, but don’t take any risk where you and all of your colleagues may end up searching for new work. It’s not worth it.

Beyond that, to those that structure bonus pay, be balanced in the incentives that you give. Let them benefit from their individual efforts, but also benefit from the long-run safety and profitability of the firm as a whole. That will result in the greatest benefit for all.

On Finding a Job in Finance

Posted on 19 December 2017 by David Merkel

I was approached by a younger friend for advice.? This is my response to his questions below:

Thank you for agreeing to do this for me. I would love to have an actual conversation with you but unfortunately, I think that between all of the classes, exams, and group project meetings I have this week it would prove to be too much of a hassle for both of us to try to set up a time.

1. What professional and soft skills do you need to be successful in this career and why?
2. What advice would you give to someone considering working in this field?
3. What are some values/ethics that have been important to you throughout your career?
4. I understand that you currently run a solo operation, but are there any leadership skills you have needed previously in your career? Any examples?
5. What made you decide to make the switch to running your own business?

Thanks again,

ZZZ

What professional and soft skills do you need to be successful in this career and why?

I’ve written at least two articles on this:

How Do I Find a Job in Finance?

How Do I Find a Job in Finance? (Part 2)

Let me answer the question more directly.? You need to understand the basics of how businesses operate.? How do they make money?? How do they control risk?

Now, the academics will show you their models, and you should know those models.? What is more important is understanding the weaknesses of those models because they may weakly explain how stocks in aggregate are priced, but they are little good at understanding how corporations operate.? The real world is not as ideal as the academic economists posit.

It is useful to read broadly.? It is useful to dig into a variety of financial reports from smaller firms.? Why smaller firms?? They are simpler to understand, and there is more variation in how they do.? ?Learn to read through the main financial statements well.? Understand how the income statement, balance sheet, and cash flow statement interact.? Look at the footnotes and try to understand what they mean.? Pick an industry and compare all of the companies.? I did that with trucking in 1994 and learned a boatload.? This aids in picking up practical accounting knowledge, which is more powerful when you can compare across industries.

As for soft skills, the ability to deal with people on a firm and fair basis is huge.? Keeping your word is big as well.? When I was a bond trader, I ate losses when I made promises on trades that went wrong.? In the present era, I have compensated clients for losses from mistaken trades.

Here’s another “soft” skill worth considering.? Many employers are aghast at the lousy writing skills of young people coming out of college, and rightly so.? Make sure that your ability to communicate in a written form is at a strong level.

Oral communication is also important.? If you have difficulty speaking to groups, you might try something like Toastmasters.

Many of these things come only with practice on the job, so don’t think that you have to have everything together in order to do well — the important thing is to improve over time.? Young people are not expected to be as polished as their older colleagues.

What advice would you give to someone considering working in this field?

It’s a little crowded in finance.? That is partially because it attracts a lot of people who think it will be easy money.? If you are really good, the crowding shouldn’t be much of a hurdle.? But if you don’t think that you are in the top quartile, there are some alternatives to help you grow and develop.

Consider developing your skills at a small bank or insurer.? You will be forced to be a generalist, which sets you up well for future jobs.? It also forces you to confront how difficult the economics of smaller firms are, and how costly/difficult it is to change strategy.? For a clever person, it offers a lot of running room if you work for a firm that is more entrepreneurial
Or, consider working in the finance area of an industrial firm.? Finance is not only about selling financial products — it is about the buyers as well.
Work for a government or quasi-governmental entity in their finance area.? If you can show some competence there, it would be notable.? The inefficiencies might give you good ideas for what could be a good business.

What are some values/ethics that have been important to you throughout your career?

Here are some:

Be honest
Follow laws and regulations
Work hard for your employer
Keep building your skills; at 57, I am still building my skills.
Don’t let work rob you of other facets of life — family, friends, etc.? Many become well-paid slaves of their organization, but never get to benefit personally outside of work.
Avoid being envious; just focus on promoting the good of the entity that you work for.
Try to analyze the culture of a firm before you join it.? Culture is the most important aspect that will affect how happy you are working there.

I understand that you currently run a solo operation, but are there any leadership skills you have needed previously in your career? Any examples?

This is a cute story:?Learning Leadership.? I have also written three series of articles on how I grew in the firms that I worked for:

There’s a lot in these articles.? They are some of my best stories, and they help to illustrate corporate life.? Here’s one more:?My 9/11 Experience.? What do you do under pressure?? What I did on 9/11 was a good example of that.

I know I have a lot more articles on the topic on this, but those are the easiest to find.

What made you decide to make the switch to running your own business?

I did very well in my own investing from 2000-2010, and wanted to try out my investing theories as a business.? That said, from 2011-2017, it worked out less well than I would have liked as value investing underperformed the market as a whole.

That said, I proceed from principle, and continue to follow my investment discipline.? It follows from good business management principles, and so I continue, waiting for the turn in the market cycle, and improving my ability to analyze corporations.

Nonetheless, my business does well, just not as well as I would like.

I hope you do well in your career.? Let me know how you do as you progress, and feel free to ask more questions.

The Rules, Part LXIII

Posted on 4 March 2017 by David Merkel

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Onto the next rule:

“We pay disclosed compensation. ?We pay undisclosed compensation. ?We don’t pay both?disclosed compensation?and undisclosed compensation.”

I didn’t originate this rule, and I am not sure who did. ?I learned it at Provident Mutual from the Senior Executives of Pension Division when I worked there in the mid-’90s. ?There is a broader rule behind it that I will get to in a moment, but first I want to explain this.

There are many efforts in business, particularly in sales, where some?want to hide what they are truly making, so that they can make an above average income off of the unsuspecting. ?At the Pension Division of Provident Mutual, the sales chain worked like this: our representatives would try to sell our investment products to pension plans, both municipal and corporate. ?We preferred going direct if we could, but often there would be some fellow who had ingratiated himself with the plan sponsor, perhaps by providing other services to the pension plan, and he would become a gateway to the pension plan. ?His recommendation would play a large role in whether we made the sale or not.

Naturally, he wanted a commission. ?That’s where the rule came in, and from what I?remember at the time, many companies similar to us did not play by the rule. ?When the sale was made, the client would see a breakdown of what he was going to be charged. ?If we were paying disclosed compensation to the “gatekeeper,” we would point it out and mention that that was *all* the gatekeeper was making. ?If the compensation was not disclosed, the client would see the bottom line total charge, and he would have to evaluate if that was good or bad deal for plan participants.

Our logic was this: the plan sponsor would have to analyze the total cost anyway for a bundled service against other possible bundled and unbundled services. ?We would bundle or unbundle, depending on what the gatekeeper and client wanted. ?If either wanted everything spelled out we would do it. If neither wanted it spelled out, we would only provide the bottom line.

What we would never do is provide a breakdown that was incomplete, hiding the amount that the gatekeeper was truly earning, such that client would see the disclosed compensation, and think that it was the entire compensation of the gatekeeper.

We were the smallest player in the industry as far as life insurers went, but we were more profitable than our peers, and growing faster also. ?Our business retention was better because compensation surprises did not rise up to bite us, among other reasons.

Here’s the broader rule:

“Don’t be a Pig.”

Some of us?had a saying in the Pension Division, “We’re the good guys. ?We are trying to save the world for a gross margin of 0.25%/year on assets, plus postage and handling.” ?Given that what we did had almost no capital requirements, that was pretty good.

Most scandals over pricing involve some type of hiding. ?Consider the pricing of pharmaceuticals. ?Given the opaqueness is difficult to tell who is making what. ?Here is another?article on the same topic?from the past week.

In situations like this, it is better to take the high road, and make make your pricing more transparent than your competitors, if not totally transparent. ?In this world where so much data is shared, it is only a matter of time before someone connects the dots on what is hidden. ?Or, one farsighted competitor (usually the low cost provider) decides to lay it bare, and begins winning business, cutting into your margins.

I’ll give you an example from my own industry. ?My fees may not be the lowest, but they are totally transparent. ?The only money I make comes from a simple assets under management fee. ?I don’t take soft dollars. ?I make money off of asset management that is?aligned with what I myself own. ?(50%+ of my total assets and 80%+ of my liquid assets are invested exactly the same as my clients.)

Why should I muck that up to make a pittance more? ?It’s a nice model; one that is easy to defend to the regulators, and explain to clients.

We probably would not have the fuss over the fiduciary rule if total and prominent disclosure of fees were done. ?That said, how would the brokers have lived under total transparency? ?How would life insurance salesmen live? ?They would still live, but there would be fewer of them, and they would probably provide more services to justify their compensation.

Even as a bond trader, I learned not to overpress my edge. ?I did not want to do “one amazing trade,” leaving the other side wounded. ?I wanted a stream of “pretty good” trades. ?An occasional tip to a broker that did not know what he was doing would make a “friend for life,” which on Wall Street could last at least a month!

You only get one reputation. ?As Buffett said to the Subcommittee on Telecommunications and Finance of the Energy and Commerce Committee of the U.S. House of Representatives back in 1991 regarding Salomon Brothers:

I want the right words and I want the full range of internal controls. But I also have asked every Salomon employee to be his or her own compliance officer. After they first obey all rules, I then want employees to ask themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper, to be read by their spouses, children, and friends, with the reporting done by an informed and critical reporter. If they follow this test, they need not fear my other message to them: Lose money for the firm, and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless.

This is a smell test much like the Golden Rule. ?As Jesus said, “Therefore, whatever you want men to do to you, do also to them, for this is the Law and the Prophets.” (Matthew 7:12)

That said, Buffett’s rule has more immediate teeth (if the CEO means it, and Buffett did), and will probably get more people to comply than God who only threatens the Last Judgment, which seems so far away. ?But I digress.

Many industries today are having their pricing increasingly disclosed by everything that is revealed on the Internet. ?In many cases, clients are asking for a greater justification of what is charged, or, are looking to do price and quality comparison where they could not do so previously, because they did not have the data.

Whether in financial product prices, healthcare prices, or other places where pricing has been bundled and secretive, the ability to hide is diminishing. ?For those who do hide their pricing, I will offer you one final selfish argument as to why you should change: given present trends, in the long-run, you are fighting a losing battle. ?Better to earn less per sale with happier clients, than to rip off clients now, and lose then forever, together with your reputation.

Everyone Needs Good Advice

Posted on 18 February 201719 February 2017 by David Merkel

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I am a fiduciary in my work that I do for my clients. I am also the largest investor in my own strategies, promising to keep a minimum of 80% of my liquid net worth in my strategies, and 50% of my total net worth in them (including my house, etc.).

I believe in eating my own cooking. ?I also believe in treating my clients well. ?I’ve treated part of this in an earlier post called?It?s Their Money, where I describe how I try to give exiting clients a pleasant time on the way out. ?For existing clients, I will also help them with situations where others are managing the money at no charge, no payment from another party, and no request that I manage any of those assets. ?I do that because I want them to be treated well by me, and I know that getting good advice is hard. ?As I wrote in a prior article?The Problem of Small Accounts:

We all want financial advice.? Good advice.? And we want it for free.? That?s why we come to the Aleph Blog, where advice is regularly dispensed, and at no cost.

But? I can?t be personal, and give you advice that is tailored to your situation.? And in my writing here, much as I try to be highly honest, I am not acting as a fiduciary, even though I still make my writings hold to such a standard.

Ugh.? Here?s the problem.? Good advice costs money.? Really good advice costs a lot of money, and is worth it, if you have enough money to spread the cost over.

But when you have a small account, you have a problem in getting advice.? There is no way for someone who is fiduciary (like me) to make money addressing your concerns.? That is why I have a high minimum for investing: $100,000.? With that, I can spend time on clients, even helping them with assets from which I make no money.

What extra things have I done for clients over time? ?I have:

Analyzed asset allocations.
Analyzed the performance of other managers.
Advised on changing jobs, negotiating salary, etc.
Explained the good and bad points of certain insurance companies and their policies, and suggested alternatives.
Analyzed chunky assets that they own elsewhere, aiding them in whether they keep, sell, or sell part of the asset.
Analyzed a variety of funky and normal investment strategies.
Advised on buying a building, and future business plans.
Told a client he was better off reinvesting the slack funds in his business that needed?financing, rather than borrow and invest the funds with me.
Told a client to stop sending me money, and pay down his mortgage. ?(He has since resumed sending money, but he is now debt-free.)

I take the fiduciary side of this seriously, and will?tell clients that want to put a?lot of their money in my stock?strategy that they need less risk, and should put funds in my bond strategy, where I earn less.

I’ve got a lot already. ?I don’t need to feather my nest at the expense of the best interests of my clients.

Over the last six years, around half of my clients have availed themselves of this help. ?If you’ve read Aleph Blog for awhile, you know that I have analyzed a wide number of things. ?Helping my clients also sharpens me for understanding the market as a whole, because issues come into focus when the situation of a family makes them concrete.

So informally, I am more than an “investments only” RIA [Registered Investment Advisor], but I only earn money off of my investment fees, and no other way. ?Personally, I think that other “investments only” RIAs would mutually benefit their clients if they did this as well — it would help them understand the struggles that they go through, and inform their view of the economy.

Thus I say to my competitors: do you want to justify your fees? ?This is a way to do it; perhaps you should consider it.

Postscript

Having some people in an “investment only” shop that understand the basic questions that most clients face also has some crossover advantages when it comes to understanding financial companies, and different places that institutional money gets managed. ?It gives you a better idea of the investment ecosystem that you live and work in.

Book Review: The Difference

Posted on 16 February 201716 February 2017 by David Merkel

In general, I don’t like books on personnel management. ?That’s mostly because good management techniques are mostly obvious, and there are typically a lot of good strategies that are somewhat different, and most of them will work, if applied with a little common sense. ?Pick one. ?Apply it. ?Be consistent. ?Get feedback. ?Adjust. ?Repeat.

No one has the “holy grail.” ?That is true of this book also. ?What I appreciate about “The Difference” is its emphasis on creating a good culture. ?I’ve worked in companies with good cultures, bad cultures and mixed cultures. ?What?Subir?Chowdhury gets right is the key difference is attitude, and it flows from the top.

Some?firms fail because employees are afraid to tell the truth. ?That was true within areas of AIG when I worked for it. ?Do you want?a culture based on truth? ?Be honest, ask for it from your bosses, and expect it from your subordinates. ?Don’t punish anyone for telling the truth; instead reward it.

Some firms fail because of a lack of emphasis on quality. ?The need for short-term profits outweighs quality products and services. ?Low quality is a cancer — it can spread from employee relationships to products, services, accounting, vendor relations, marketing, etc. ?Cultural change is needed, starting at the top. ?If management doesn’t put quality ahead of short term profits, quality will not characterize a company. ?Management has to lead efforts on quality by example, instructions, and rewards. ?Employees won’t care about quality if management doesn’t care about them, and reward them for stopping bad quality even if it slows production.

The book takes an approach like this, only much better than I can. ?It provides a cutesy acronym to summarize the approach for creating a great corporate culture, which to me trivializes ideas, but aids memory for others.

The author peppers the book with his experiences in his life ?and work, from youth to the present. ?I found those to be a mixed bag. ?Like most people, a lot of it sounds like he is tooting his own horn repeatedly. ?Many of them are quite instructive, a few aren’t. ?I particularly found his example of giving to beggars to be weak. ?Yes, the poorest need money, but what they need more is relationships. ?The poorest lose relationships due to disease, accidents, substance abuse, selfishness on the part of their family and their own selfishness, an attitude of blaming the world around rather than look at their own failures, and more.

Giving them money does not break the problem; it often feeds the problem. ?Creating relationships for them can allow them to reboot their lives, if they want to live a new life. ?Don’t get me wrong; I’m no great shakes here. ?I just know that the poorest need radical personal change if they ever want to escape their poverty. ?Money won’t make the difference necessary most of the time.

That last rant aside, I liked the book and would recommend it. ?It’s kind of expensive for its size, but maybe you want a short book that you can read in 1-2 hours. ?You’ll get enough to make you think, and maybe make a difference. ?It’s “good enough” to help you, but not outstanding.

Quibbles

Already mentioned.

Summary / Who Would Benefit from this Book

You may not need another management book. ?If you need something short to motivate a need for corporate and personal change, this could be the book for you.? If you want to buy it, you can buy it here: The Difference: When Good Enough Isn’t Enough.

Full disclosure:?The publisher asked me if I wanted a free copy and I assented.

If you enter Amazon through my site, and you buy anything, including books, I get a small commission. This is my main source of blog revenue. I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

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

Of Milk Cows and Moats

Posted on 21 October 2016 by David Merkel

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Before I write my piece, I want to say a word about the virtue of voting for third party candidates for President. ?Personally, I would like to see an option where we can vote for None of the Above, on all races. ?That would allow us to break the duopolistic power of the Democrats and Republicans without having to have a viable third party. ?The ability to reject all of the candidates so that a new election would have to be held with new candidates would be powerful, and would make both parties more sensitive to all of the voters, not just minorities on the left and right.

Still, I’m voting for a third party candidate mostly as a protest. ?I consider the protest to be an investment, because it has no value for the current election, but may have value for future elections if it teaches the two main parties that they no longer have a stranglehold on the electorate. ?The cost of doing so in this election for President is minuscule, because both candidates are dishonest egotists.

Character matters; if a person is not honest you will not get what you thought you were voting for. ?In this election, more than most, people are projecting onto Hillary and Donald what they want to see. ?Trump is not a man of the people, and neither is Clinton. ?They are both elitist snobs; they are members of rival cliques that dominate their respective parts of the main country club that the privileged enjoy.

There is no loss in not voting for them. ?If you want to send a message, vote for someone other than Clinton or Trump.

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Of Milk Cows and Moats

It’s become fashionable to talk about moats in investing as an analogy for sustainable competitive advantages. ?Buffett popularized it, and many use it in investment analysis today. ?Morningstar has made a lot out of it.

I’d like to talk about the concept from a broader societal angle. ?This may look like a divergence from talk on investing, but it does have a significant influence on some investing.

I live in the great state of Maryland. ?A while ago, I wrote an award-winning piece on publicly traded companies in Maryland. ?My main conclusion was that many corporations are?in Maryland because the founder lived here. ?Other corporations were in Maryland because of the talent available to manage healthcare firms, defense firms, hotels, and REITs. ?Only the last one, REITs, had any significant advantage imparted by the state itself — Maryland was the first state with a statute allowing for REITs.

Why do corporations leave Maryland? ?Well, when a merger takes place, the acquirer usually figures out that the company would likely be better off reducing its presence in Maryland, and increasing its presence elsewhere. ?Costs, taxes and regulation will be lower. ?The countervailing advantage of an educated workforce is usually not enough to keep jobs here, unless that is the main input to what the firm does, such as biotechnology — hard to beat the advantage of having Johns Hopkins, NIH, and the University of Maryland nearby.

All of this suggests a model of businesses and people entering and leaving an area that is akin to the moats we describe in business. ?Most businesses know that it will be expensive to move.

They will lose people, or, it will be costly to move them
There will be an interruption to operations in some ways.
The educational quality of people might not be as great in the new area.
Some taxes and regulations could be higher.

Thus to induce a move, another municipality might offer incentives of tax abatement, a low interest loan, etc. ?The attracting municipality is making a business decision — what do they give up in taxes (and have to spend on services) versus what they gain in other taxes, etc. ?The attracting municipality also assumes that there will be some stickiness when the incentives run out. ?If you need an analogy, it is not that much different than what it takes to attract and retain a major league sports franchise.

What municipalities lose businesses and people? ?Those that treat them like milk cows. ?Take a look at the states, counties and cities that have lost vitality, and will find that is one of the two factors in play, the other being a concentrated industry mix in where the dominant industry is in decline.

The more a municipality tries to milk its businesses and people, the more the businesses begin to hit their flinch point, and look for greener pastures. ?With the loss of businesses and people, they may try to raise taxes to compensate, leading to a self-reinforcing cycle that eventually leads to insolvency.

A municipality can fight back by offering its own incentives to retain companies and people. ?This can lead to a version of the prisoners’ dilemma, or a “race to the bottom” as corporations play off municipalities against each other in order to get the best deal possible. ?There is an analogy to war here, because the mobile enemy has significant advantages. ?There is an analogy to antitrust as well, because municipal governments are allowed to collude against corporations, and it would be to their advantage to do so, if they could agree.

In a game like this, the healthiest municipalities have the strongest bargaining position — they can offer the best deals. ?There is a tendency for the strong to get stronger and the weak weaker. ?Past prudence has its rewards. ?Present prudence is costly, both economically and politically, is difficult to achieve, and?future people will benefit who will not remember you politically.

One more note: Maryland has another problem, which affects some of my friends in the industry who have Maryland-centric.investment management practices. ?(My firm is national. ?More of my clients are outside of Maryland than inside.) ?When wealthy people in Maryland retire, their probability of leaving Maryland goes up, as the “moat” of their Maryland job disappears. ?Again states can adjust their tax policies to try to retain people in their states. ?On the other hand, some attempt to tax former residents who earned their pensions in their states, and things like that.

This is just another example of how municipalities have limits to the amount they can tax before the tax base erodes.

(Dare we mention how the internet is still costing states some of their sales taxes? ?Nah, too well known.)

Upshot

When considering businesses that rely on a given locality, ask how the health of the locality affects the business. ?It’s worth considering. ?For those who invest in municipal bonds, it is a critical factor. ?Particularly as the Baby Boomers age, weak municipalities will come under pressure. ?Stick with strong municipalities, and services that would be impossible to do without.

Finally, think about your own life. ?Is it possible:

that your firm could move and leave you behind?
that your taxes could rise significantly because businesses and people are leaving?
that your taxes could rise significantly because state employee benefit plans are deeply underfunded?
that your municipal job could be put in danger because of prior weak economic decisions on the part of the municipality?
that real estate prices could fall if the exodus of people from your area accelerates?
Etc.

Then consider what your own “plan B” might be, and remember, earlier actions to leave are better actions if you are correct. ?The options are always lousy once an economic bust arrives.

What to do when Ethics are Discouraged

Posted on 18 August 201618 August 2016 by David Merkel

Photo Credit: elycefeliz || Enron and some other US corporations have been ethics-hostile places also

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Yesterday I gave a talk on ethics to the incoming class at?The Johns Hopkins Carey Business School. ?As some of you might know, I received my BA and MA from Johns Hopkins in 1982 long before they had a business school. ?It was fun to talk to all of the entering MBA students who came to the school from all over the world. ?It largely serves international students.

At the end of my talk I took questions, both formally, and informally after the talk was over. ?The biggest question was, “Mr. Merkel, what you say about ethics might be the best policy for business in the US, but when I return to my home country, it will not be well-received. ?What should I do?”

This is a tough one. ?I think people have an easier time missing out on gains by being ethical than losing one’s job. ?But let me give a few ideas anyway.

Many countries where business ethics aren’t practiced set themselves up for financial crises and scandals. ?One strategy could be to bide your time and wait for the next large scandal or crisis. ?Then suggest to your management (assuming your firm survived) that managing in an ethical way could prevent these problems, and potentially attract more business to your firm.
Take a chance and try to create your country’s equivalent of Vanguard. ?Low cost, mostly passive investing, owned by clients, limited management salaries, etc.
Same as #2, but if you get the chance to start or run any firm, adopt ethical practices and make it a selling point. ?You could be the start of cultural change. ?(Now elements of that could prove difficult if there are government officials expecting bribes… how you work that out is difficult. ?Friends of mine working as missionaries in corrupt countries tell me that you can still get things done without bribes, but it takes longer, with more effort.)
Suggest to government ministers that a lack of ethics holds back growth. ?Countries with no bribery, low corruption, and moderate regulations tend to grow faster.
Propose small experiments in your firm testing whether an ethical approach will produce better results.
Consider working for a foreign firm in your country if they have ethical standards.
Consider gaining experience in a country other than your home country, and propose to that firm that they try setting up a subsidiary in your home country.
On the side, develop a voluntary organization that promotes ethical business conduct. ?Consider publishing some books that point out how unscrupulous business practices are harming most people. ?Recruit well-known foreign businessmen known for clean business practices to come talk in your country.

I can’t think of anything more right now. ?Readers, if you can think of other ideas, please mention them in the comments. ?Thanks.

PS — One more note, having worked for a few firms that were ethics-challenged as far as accounting and sales practices went, I can say that trying to promote change from inside is tough. ?Taking a job at another firm was my way out of those situations. ?No surprise that almost all of those firms failed.

If Someone Tries to Sell You, Don’t Buy It

Posted on 19 March 201620 March 2016 by David Merkel

Picture Credit: Arturo de Albornoz || "Do unto others, as you would have others do unto you." -- Y'Shua Ha'Mushiach — Picture Credit: Arturo de Albornoz || “Do unto others, as you would have others do unto you.” — Y’shua Ha’Mushiach

This is an extension of a recent piece?Decline Free Food. ?Things have gotten worse with the mail situation at the Merkel house as I get older. ?It’s not enough that AARP keeps sending us offers join. ?(I keep a pile of AARP cards next to my work area to snip up if I am feeling blue. 😉 ) ?Now that I have turned 55, I am getting a flood of invitations from ~~bloodsuckers~~ financial services marketers asking me to come to their free information session.

The three recent ones were:

A conference asking “DO YOU HAVE THE COURAGE TO RETIRE RICH?” ?The answer is real estate speculation. ?Ah, if it were only that easy. ?Yes, I know that a tiny amount of flipping has been profitable of late. ?The only thing more profitable than flipping and speculating is getting others to pay for your advice and services so that they can go out and lose money speculating and flipping. ?As I said to the guy pitching at a “Rich Dad” seminar, “If there’s that much money lying around in mispriced properties, why not go start a REIT and vacuum up all that money yourself?” ?His answer, “What’s a REIT?” ??I said, “If you don’t know that, you don’t know real estate.”
The pitch: “In a moment of decision the best thing you can do is the right thing. ?The worst thing you can do is nothing. — Theodore Roosevelt” ?A little more classy, but wrong. ?Often the right thing to do is nothing, particularly if you don’t know the right answer… better to wait, study and learn. ?Don’t be biased toward action, particularly in investing. ?Only a salesman wants you biased toward action, and that is for his good, not yours. ?In this case, the course offered doesn’t look so bad, and the price is cheap — but they don’t care about the cost of the course aside from the fact that it psychologically commits you to the course, and that you will more likely come, and be more likely to purchase further services from them. ?The biggest thing you would learn from the course is that you don’t know much… so buy their services.
The next one advertises a dinner. ?This one tries to scare you into coming — there’s a crisis around the corner. Boo! ?But we can keep your retirement safe. ?Inflation is coming. ?Boo! ?But we will get you an income that keeps up with inflation. ?Then, to aid credibility, it mentions that their firm has been mentioned in a variety of local newspapers that no one pays for that cumulatively have less reach than this blog.

When I recently went and spoke to the Baltimore chapter of the American Association of Individual Investors, I told them, “I’m not going to market anything to you,” and I didn’t. ?I response to a question, I did show them a page from my blog. ?Yes, the one that lists all my worst mistakes. ?And, I took a fairly extensive Q&A where if I didn’t know an answer, or there wasn’t a good answer, I said so.

My credibility is worth more to me than a little business. ?Beyond that, I never want a client to think that I goaded him into working with me, or, that I went overboard to retain him if he wants to leave. ?After all, I say to them, “It?s Their Money.”

As I often say:

?Don?t buy what someone else wants to sell you. ?Buy what you have researched that you want to buy.?

I would say if someone sends you a slick ad on financial services, ignore them. ?Always. ?Do your own research. ?The best firms don’t advertise, because they don’t have to. ?Talk to intelligent friends, and see what they do. ?Ask investment managers if they died and their firm went out of business, who would they want their spouse to use?

Don’t respond to retirement, investment management and financial planning ads. ?Develop your own proposal, and put it out for bid. ?Let multiple providers tell you what they will do for you. ?Have smart friends help you review the submissions. Then choose the best one.

Keep the hucksters and charlatans at bay. ?Ignore them.