Speculation – Page 10 – The Aleph Blog

Book Review: Octopus

Posted on 7 August 2013 by David Merkel

This is not a normal book for me to review.? The claims made by the book are fantastic, and the subject of the book, Sam Israel, would have a strong motive for self-exoneration.? But with any book, unless you have direct insight into what the book talks about, you have to interpret the book consistently, assuming the author has told the truth.? That is what I will do.

I have a saying, “It is very difficult to cheat an honest man.” Why is that so?? An honest man knows that few things come easy in life, and so if something seems too good to be true, he will avoid someone peddling something that is likely to be a scam.

But someone who thinks the world is inherently crooked is much easier to cheat, because he thinks that he will be able to outfox others trying to cheat him.? He is more vulnerable to playing an inside game that few others know about.

Sam Israel drifted into a Ponzi scheme.? He may not have intended to do so, but once you report fake results that are too good, it is difficult to ever come back to true accounting, because the assets have to earn considerably more than average in order to break even.? New money helps a lot, and that is driven by great returns, so there is the incentive to keep reporting “too good” returns.

It’s a treadmill, which is why Ponzi schemes always blow up.? In Sam Israel’s case, it led to all manner of speculative investments that an ordinary investor would never touch.? In the second half of the book, it led to dealing with a smooth-talking guy who charmed and scammed Sam Israel, convincing him that there was a conspiracy that controlled Western governments with a rigged bond market that offered incredible deals to insiders.

Now, to me, anything that seems too complicated to justify the worldview is probably not true.? What reason would a conspiracy have to hand out risk-free profits to anyone?? Governments or conspirators would pocket the money themselves, and would not let anyone else in.? But to a crooked mind that needs an easy win in order to set all things right, this is a perfect setup to separate a fool and his money (or rather, the money of his clients).

As it was, Sam Israel ran out of money and his “hedge fund” collapsed, leaving many foolish investors to mourn their losses.

One more thing: a undercurrent of the book was how they managed to co-opt the auditors.? Beware trusting small no-name auditors.

Quibbles

The book is well-written, and if you take it as fiction, it is a real page-turner.? But as truth, you are reliant on a few voices, mostly Sam Israel and his friends, to tell you what happened.? I’m reluctant to sign onto that, but I can’t fully rule it out either.

Who would benefit from this book: If you like fiction, you will like this.? If you want to look into the pathology of a Ponzi Scheme, it is good there also.? If you like reading sordid tales of greed, foolishness, and lies, you will like it.? Otherwise, avoid.? If you want to, you can buy it here: Octopus: Sam Israel, the Secret Market, and Wall Street’s Wildest Con.

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

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

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

Not Natural Gas, Just Flatus

Posted on 26 July 2013 by David Merkel

Okay, time for the promoted stock scoreboard:

Ticker	Date of Article	Price @ Article	Price @ 7/25/13	Decline	Annualized	Splits
GTXO	5/27/2008	2.45	0.008	-99.7%	-67.1%
BONZ	10/22/2009	0.35	0.002	-99.3%	-73.5%
BONU	10/22/2009	0.89	0.005	-99.4%	-74.3%
UTOG	3/30/2011	1.55	0.005	-99.7%	-91.5%
OBJE	4/29/2011	116.00	0.315	-99.7%	-92.9%	1:40
LSTG	10/5/2011	1.12	0.032	-97.2%	-86.2%
AERN	10/5/2011	0.0770	0.0002	-99.7%	-96.3%
IRYS	3/15/2012	0.261	0.003	-98.9%	-96.3%
NVMN	3/22/2012	1.47	0.300	-79.6%	-69.4%
STVF	3/28/2012	3.24	0.348	-89.3%	-81.4%
CRCL	5/1/2012	2.22	0.040	-98.2%	-96.2%
ORYN	5/30/2012	0.93	0.085	-90.9%	-87.5%
BRFH	5/30/2012	1.16	0.450	-61.2%	-56.1%
LUXR	6/12/2012	1.59	0.016	-99.0%	-98.4%
IMSC	7/9/2012	1.5	1.140	-24.0%	-23.1%
DIDG	7/18/2012	0.65	0.052	-92.0%	-91.6%
GRPH	11/30/2012	0.8715	0.136	-84.4%	-94.3%
IMNG	12/4/2012	0.76	0.160	-78.9%	-91.3%
ECAU	1/24/2013	1.42	0.318	-77.6%	-95.0%
DPHS	6/3/2013	0.59	0.040	-93.2%	-100.0%
POLR	6/10/2013	5.75	0.510	-91.1%	-100.0%
NORX	6/11/2013	0.91	0.510	-44.0%	-99.2%
ARTH	7/11/2013	1.24	0.550	-55.6%	-100.0%

	7/25/2013		Median	-92.0%	-91.6%

Tonight’s loser in waiting is North American Oil & Gas Corp [NAMG].? Formerly known as CalendarDragon, a software company, it became North American Oil & Gas.? If the company were as good as the promoter says it is, it would never have bought a penny stock shell.? It would have negotiated with private equity companies.? Why would you make great claims, and yet:

Have negative income, always
Negative net worth
No revenues, always

Note the risk factor from the 8-K:

We have no oil or gas reserves, and the probability of an individual prospect ever having oil and gas is extremely remote and therefore any funds we spend on exploration will likely be lost.

?

The probability of an individual prospect ever having oil and gas is extremely remote. In all probability, the property does not contain any oil and gas. As such, any funds spent on exploration will probably be lost which will have a negative effect on our operations and a loss of your investment.

This is a constant with promoted stock scams.? They work on dud companies, then a promoter tells a story.? The SEC should prosecute such newsletter writers.? The scams could not work without them, at least for now.

Anyway, expect losses here, as usual.? The major energy companies have a far better idea of where they can find energy than a few people can.

Finally, please note in the 4-point type that the writer is getting paid over $100,000 to write the piece, and he does not have a lot of costs, because it is done online.? I saw the ad at Bloomberg.com.? Hey, Michael Bloomberg, Hopkins Grad like me!? Do you want to be associated with penny stock promotions?? You don’t have enough money already?

This stuff stinks.? Really stinks, like flatus.

The Rules, Part XLVI

Posted on 20 July 2013 by David Merkel

Speculative companies should be evaluated on cash, burn rate, probability of success, size of potential market and margins at maturity.

I rarely buy speculative companies, but it is an interesting question as to how speculative companies like Amazon, Google, or a biotech firm should be valued.? Speculative companies are like options; they often end with no value, and occasionally end with a large value.

Here are my five points:

Cash
Burn rate
Probability of success
Size of potential market, and
Margins at maturity.

Cash and burn rate tell you how long the company has to play before it fails.? If a company is spending cash in an effort? to produce a profitable business, how long can it do so until it runs out of cash?

That plays into the probability of success — more time means a higher probability, mostly, but desperation can aid success.? Other aspects on probability of success include the competition, novelty/reliability of the science, etc.

If the strategy does succeed, how large could the market be that is served, and how big could the margins be as part of an oligopoly?

But after all that, discount for the probability of failure, and discount the future earnings stream at 20%/year, because this is so uncertain.

As I said to colleagues at one firm I worked for in 2004, “Imagine Google gets 20% of the profits of the global advertising business 10 years out, and holds onto it?? What would that be worth?”

It would be worth a lot, and Google has probably exceeded that profitability estimate, thus the high market valuation of Google.? Give credit to people with clever ideas at the right time.

Anyway, be careful investing in speculative companies — this is an area where you will get more strikeouts than home runs.? I tend to be a singles hitter in investing, but with a high average.? But in the few cases where I look at a speculative company, this is how I do it.

Bandaging Wounds from Another Promoted Stock Scam

Posted on 11 July 2013 by David Merkel

Okay, time for the promoted stock scoreboard:

Ticker	Date of Article	Price @ Article	Price @ 7/11/13	Decline	Annualized	Splits
GTXO	5/27/2008	2.45	0.012	-99.5%	-64.6%
BONZ	10/22/2009	0.35	0.003	-99.3%	-73.2%
BONU	10/22/2009	0.89	0.003	-99.7%	-78.6%
UTOG	3/30/2011	1.55	0.005	-99.7%	-91.9%
OBJE	4/29/2011	116.00	0.305	-99.7%	-93.3%	1:40
LSTG	10/5/2011	1.12	0.031	-97.2%	-86.9%
AERN	10/5/2011	0.0770	0.0003	-99.6%	-95.7%
IRYS	3/15/2012	0.261	0.003	-98.9%	-96.7%
NVMN	3/22/2012	1.47	0.300	-79.6%	-70.5%
STVF	3/28/2012	3.24	0.330	-89.8%	-83.1%
CRCL	5/1/2012	2.22	0.031	-98.6%	-97.2%
ORYN	5/30/2012	0.93	0.154	-83.4%	-80.1%
BRFH	5/30/2012	1.16	0.458	-60.5%	-56.6%
LUXR	6/12/2012	1.59	0.017	-98.9%	-98.5%
IMSC	7/9/2012	1.5	1.260	-16.0%	-15.9%
DIDG	7/18/2012	0.65	0.058	-91.1%	-91.5%
GRPH	11/30/2012	0.8715	0.141	-83.8%	-94.9%
IMNG	12/4/2012	0.76	0.150	-80.3%	-93.3%
ECAU	1/24/2013	1.42	0.360	-74.6%	-94.9%
DPHS	6/3/2013	0.59	0.040	-93.2%	-100.0%
POLR	6/10/2013	5.75	0.600	-89.6%	-100.0%
NORX	6/11/2013	0.91	0.440	-51.6%	-100.0%

	7/11/2013		Median	-92.1%	-92.6%

They are predictably bad.? If anything, the last few promoted stocks have been exceptionally bad.? It makes me wonder whether players play the pump of the pump and dump are getting too numerous.? Maybe after a few more losses like POLR & NORX, there will be fewer players willing to speculate on companies with price momentum that are obviously bogus.

Tonight’s loss-to-be is Arch Therapeutics.? It was a distributor of auto parts that never made a dime of revenue called Almah, Inc., until four months ago.? It did the following:

On April 19, 2013, the Company entered into a Binding Letter of Intent (the ?LOI?) with Arch Therapeutics, Inc., a Massachusetts company (?Arch?), in connection with a proposed reverse acquisition transaction between the Company and Arch pursuant to which the Company would enter into a reverse triangular merger with Arch (the ?Merger?) and the Company would acquire all of the issued and outstanding capital stock and convertible notes and warrants of Arch in exchange for the issuance of 20,000,000 shares of the Company?s common stock to the shareholders of Arch. Arch operates as a life science company developing polymers containing peptides intended to form gel-like barriers over wounds to stop or control bleeding.

On April 19, 2013, subsequent to the Company?s fiscal quarter ended March 31, 2013, Mr. Powers resigned as the Company?s sole officer and director and Mr. Norchi was appointed as the Company?s director and sole officer, and Mr. Avtar Dhillon was appointed as a director.

On May 10, 2013, pursuant to the terms of the LOI, the Company entered into an Agreement and Plan of Merger (the ?Merger Agreement?) with Arch and Arch Acquisition Corporation, a Massachusetts corporation and the Company?s wholly-owned subsidiary (?Merger Sub?). In accordance with the Merger Agreement, Merger Sub will merge with and into Arch (the ?Merger?), with Arch surviving the Merger upon the terms and subject to the conditions set forth in the Merger Agreement.

As set forth in the Merger Agreement, the Company will acquire all of the issued and outstanding capital stock and convertible notes and warrants of Arch (through a reverse acquisition transaction) in exchange for the issuance to the holders thereof of 20,000,000 shares of the Company?s common stock. The stockholders of Arch will receive two and one-half shares of the Company?s common stock for each share of common stock of Arch held by them immediately prior to the effective time of the Merger.

Almah, no revenues, no earnings, negative net worth. Arch, a “promising” technology company that decides to buy a stock listing buying Almah in a reverse merger.? If the technology were so good, why not remain private and work with private equity, or enter into joint ventures with large medical technology companies that have incredible reach?

It beggars belief that one would merge with a virtually defunct company to build a strong medical technology company.? Leave aside all of the scam language in the promotion.? But here are some examples from the disclaimers:

Facts stated in this article were supplied to endorser from third-party sources.
XXX has been compensated $10,000 by YYY for endorsing this product, and ZZZ has been paid a $25,000 by YYY for sending out this advertisement.
YYY, the third party advertiser, has paid $390,000 USD and is expected to pay an additional $400,000 to WWW as of June 20, 2013 for this advertising effort in an effort to build investor awareness.
YYY. represents that it does not own any shares of Arch Therapeutics, Inc. (except for 2,500,000 shares of restricted stock) which YYY. will not sell, pledge or hypothecate or otherwise agree to dispose of for 90 days following the initial dissemination of this advertisement.

If I had a new way of treating wounds that was really effective, I would do it myself privately, or work with private equity.? As it is, this stock promotion is garbage, and not worthy of investment.

The only thing I can’t find is any connection between the promotion and the company.? The promotion doesn’t mention the past, and the company is seemingly not involved in the promotion.? Maybe an owner could be pushing it; they are the only ones that could profit from the promotion.

Risk Control Upfront

Posted on 25 June 2013 by David Merkel

In my career as an asset manager, and as a manager of financial risk, I have learned that all good risk management is done upfront, before the first purchase is made or product is sold.? Secondarily, good risk management relies on the concept of feedback, i. e., are the results expected at inception happening?? If not, are they happening in a way that makes us doubt the margin of safety that we thought we had?

I’ll give you some examples:

1) There are two ways to offer disability insurance (this applies to high-end P&C products for the wealthy, and other financial products):

Rigorous underwriting that does not cover groups & individuals that could be high risk.
Underwrite freely, and then attempt to deny claims that happen with higher than expected frequency.

2) After designing a living benefit for an annuity, you notice that one option is being chosen by policyholders, and the rest not.? Do you:

Retest the option being chosen, to see that you are not giving away the store?
Do nothing.? After all, it’s the only product of its class selling, and marketing is off your back for now.? Why spoil the party?

3) You discover that you are the only company willing to offer a certain type of reinsurance, or a certain type of coverage.? Do you:

Try to analyze why? your competitors don’t do it.? If there’s no special and durable barrier to entry that you possess, make the pricing jump through harder hoops.
Congratulate yourself for your unique perspective, and willing to take risks that others won’t.

4) On your new insurance product, the claims area sends you early claims data, showing you reasons for the claims.? They reasons aren’t what you would have expected from the quality of the clientele that you thought you were marketing to.? Do you:

Begin analyzing marketing data, to see if the product is being offered more to those less intended.? Analyze what agencies are doing who sell a disproportionate amount of the product.
Attribute the claims to the “Law of Small Numbers.”? Hey, it’s a weird world, and odd stuff happens.

5) You’re part of a team of value investors.? A news event hits, showing that the company will be less profitable than expected by a wide margin.? Do you:

Analyze what the company is worth presently.? If it is no longer safe or cheap, sell.? If the market has over-reacted, buy.? Oh, and feed back the lessons from this episode into the process for evaluating new investments.
Automatically sell, because it has breached your loss limits.
Just hang on, because we have more than enough capital versus investable ideas.
Complain about the event, the potential dishonesty of management, and the analyst that recommended purchase.? Ask why we didn’t sell this last week.? Decide to go activist on the company, because it obviously the assets would be managed better in hands that you select.

6) The credit cycle has gotten long in the tooth, and securities that offer a decent yield versus risks undertaken have become few.? You manage money for income seeking investors.? Do you:

Edge away from risky bonds, slowly upgrade quality, and pare yields.? Communicate to clients why you are doing this, even if it means you might see assets walk.
Stay fully invested in the best quality bonds you can find, subject to a given yield hurdle.
Just facilitate the demands of clients, and invest as if you faced normal yield tradeoffs for risks undertaken.? After all, they want you to take risks.? If clients lose, that is their problem.

7) As a value manager, you have been underperforming for clients.? Though you have tested and re-tested your processes, you can’t? find anything wrong.? You think there is a speculative mania going on.? Several other managers that do things your way have been fired.? Do you:

Stick to your guns.? Safe and cheap will eventually win out.? Communicate that to clients.
Tweak your portfolios to make them more index-like.
Switch to growth or momentum investing.? If you can’t beat them, join them.

There will be a part 2 to this piece.? I will finish up and summarize there.

One Small Victory versus Stock Promotion

Posted on 11 June 2013 by David Merkel

Okay, here’s the promoted stock scoreboard:

Ticker	Date of Article	Price @ Article	Price @ 6/11/13	Decline	Annualized	Splits
GTXO	5/27/2008	2.45	0.011	-99.6%	-65.8%
BONZ	10/22/2009	0.35	0.004	-98.9%	-71.2%
BONU	10/22/2009	0.89	0.010	-98.9%	-71.2%
UTOG	3/30/2011	1.55	0.004	-99.7%	-93.3%
OBJE	4/29/2011	116.00	0.554	-99.5%	-92.0%	1:40
LSTG	10/5/2011	1.12	0.031	-97.2%	-88.1%
AERN	10/5/2011	0.0770	0.0002	-99.7%	-97.1%
IRYS	3/15/2012	0.261	0.003	-98.9%	-97.4%
NVMN	3/22/2012	1.47	0.080	-94.6%	-90.8%
STVF	3/28/2012	3.24	0.390	-88.0%	-82.8%
CRCL	5/1/2012	2.22	0.059	-97.3%	-96.2%
ORYN	5/30/2012	0.93	0.175	-81.2%	-80.2%
BRFH	5/30/2012	1.16	0.300	-74.1%	-73.0%
LUXR	6/12/2012	1.59	0.023	-98.6%	-98.6%
IMSC	7/9/2012	1.5	1.066	-28.9%	-30.9%
DIDG	7/18/2012	0.65	0.070	-89.2%	-91.6%
GRPH	11/30/2012	0.8715	0.180	-79.3%	-94.9%
IMNG	12/4/2012	0.76	0.180	-76.3%	-93.8%
ECAU	1/24/2013	1.42	0.420	-70.4%	-96.0%
DPHS	6/3/2013	0.59	0.107	-81.8%	-100.0%

	6/11/2013		Median	-95.9%	-91.8%

Dephasium has fallen almost 82% in 6 days.? It is a definite over-achiever in losing money.

I promise this is not going to become an “all promoted stocks, all the time” blog.? I limit it to when I receive promotions.? I got another one today, this time to my e-mail.? The future loser is Norstra [NORX].? You can see a promotion like the one I saw here.

Here are the bullet points:

Never had a penny of revenue.
Consistent losses every year.
Only stays afloat by selling stock.
Auditors don’t think they are a going concern.
If management has been selling shares to get cash at $0.001, why is the stock trading near $1?

It is highly likely that this company will do badly, as have other promoted stocks that I have written about.? But here’s the fun part — I wrote to the guy whose organization sent out the promotional e-mail.? He didn’t know that they were doing that; he was concerned for the reputation of his organization, and he is putting a halt to advertising stock promotions.

And so, Aleph Blog happily takes a small victory lap.? Promoted stocks are bad enough, but when reputable firms aid them, it is far worse.

Polar Petroleum, Frozen

Posted on 10 June 2013 by David Merkel

I’m not going to run the promoted stock scoreboard again so soon, but let it be known that Dephasium has fallen ~75% in the 5 days since I wrote about it.? Put on your peril-sensitive sunglasses, here is the chart:

Yes, my article was written at the peak.? In this case the “dump” was rather violent.

But why I am I writing about promoted stocks this evening?? This morning in my e-mail, I received this [note: after a little time, this link won’t work].

But who sent it to me?? The Washington Times.? After receiving it, I sent someone in their web area this letter:

YYY,

I don?t know if you handle this aspect of Washington Times advertising, but today I received a promoted stock ad for a fraudulent company from the Washington Times via e-mail.

The company?s name is Polar Petroleum [OTCBB: POLR], a company which:

Has never earned a penny of revenue.

Was a ?technology company? until last year, ?Post Data.? From its last 10K: ?The Company intends to market a service of decommissioning electronic data storage devices, making them inoperable and thereby making the electronic data contained therein or on permanently un-recoverable.?

Is likely being used by the promoters to do a ?pump and dump,? where affiliates do a series of transactions that inflate the price of the thinly traded stock, and use this promotion to dupe people into buying out their shares at inflated prices, leaving them holding stock of a worthless company.? The net worth of the company is $0.005/share ? It trades near $5 thanks to the pump.

It?s dishonest for the Washington Times to participate in crud like this.? Why is the Times selling its reputation for a bunch of promoted stock scammers?

Sincerely,

David

PS ? I have written about this extensively.? Here is a sample:

http://alephblog.com/2013/06/03/another-lousy-promoted-stock/

To have a reputable newspaper convey the garbage that the promoters put forth is new, and worrisome.

But about the same time that I hit the “Send” button, the SEC took action.? They suspended trading in POLR.? They justified it here.? Good work, SEC!? (Can’t remember the last time I said that.)? And if you want to see the reactions of those that follow promoted stocks regarding POLR, you can see it here.

Though the loser promoting this garbage said it would go to $27, I’ll give you a different prediction: it will go to less than fifty cents within a year.? Given the actions of the SEC, it could easily go there on June 24th, when trading reopens.

Here is my advice to the SEC: maybe you could create a unit that follows promoted stock fraud, and do exactly what you have done with POLR to every promoted stock scam.? It would eliminate a significant area of fraud in our equity markets.

On the Designation of Systemically Important Financial Institutions

Posted on 5 June 2013 by David Merkel

What does it take to create a global or national financial crisis?? Not just a few defaults here and there, but a real crisis, where you wonder whether the system is going to hold together or not.

I will tell you what it takes.? It takes a significant minority of financial players that have financed long-dated risky assets (which are typically illiquid), with short-dated financing.

The short-dated financing needs to be rolled over frequently, and during a time of financial stress, that financing disappears, particularly when creditors distrust the value of the assets.? It typically happens to all of the firms with weak liability structures at the same time.

During good times financing short is cheap.? Locking in long funding is costly, but safe.? That is why many financial firms accept the asset-liability mismatch — they want to make more money in the short-run in the bull phase of the market.? But when many parties have financed long risky assets with loans that need to be renewed in the short-term, the effect on the markets is multiplied.? The value of the risky assets falls more because many of the holders have a weak ability to hold the assets.? Where will the new buyers with sound finances come from?

Areas of Short-dated Financing

Short-dated financing is epitomized by bank deposits prior? to the Great Depression.? If doubt grew about the ability of a bank to pay off its depositors, depositors would run to get their cash out of the bank.? Deposits are supposed to be available with little delay.? After creation of the FDIC, deposits under the insurance limit are sticky, because people believe the government stands behind them.

But there are other areas where short-dated financing plays a significant role:

Margin accounts, whether for derivatives, securities, securities lending, etc.? If a financial company is required to put up more capital during a time of financial stress, they may find that they can’t do it, and declare bankruptcy.? This can also apply to some securities lending agreements if unusual collateral is used, as happened to AIG’s domestic life subsidiaries.
Putable financing, particularly that which is putable on credit downgrade.? This has happened in the last 25 years with life insurers [GICs used for money market funds], P&C reinsurers, and utilities.? Now this is similar to margin agreements on credit downgrades because more capital must be posted.? Anytime a credit rating affects cash flows, it is a dangerous thing.? The downgrade exacerbates the credit stress.? Then again, why were you dancing near the cliff that you created?
Repo financing was a large part of the crisis.? The weakest large investment banks relied on short-term finance for their assets in inventory.? So did many mortgage REITs.? As repo haircuts rose, undercapitalized players had to sell, lowering asset prices, leading to a new round of selling, and higher repo haircuts.? It was the equivalent of a bank run and only the strongest survived.
Auction-rate preferreds — a stable business for so long, but when creditworthiness became a question, the whole thing fell apart.
Finance companies — GE Finance and other finance companies rely on a certain amount of short-term finance via commercial paper.? It is difficult to be significantly profitable without that.
All other short-term interbank lending.

Crises happen when there is a call for cash, and it cannot be paid because there are not enough liquid assets to make payment, and illiquid assets are under stress, such that one would not want to sell them.? This has to happen to a lot of companies at the same time, such that the creditworthiness of some moderately-well capitalized institutions, that were thought to have adequate liquidity are called into question.

The Value of a Long Liability Structure

Let me give a counterexample to show what would be a hard sort of company to kill.? In the mid-1980s, a number of long-tailed P&C reinsurers found their claims experience in a number of their lines to be ticking up dramatically.? But the claims take a long time to settle, so there was no immediate call for cash.? Later analysis showed that for many of the companies, if the full value of the claims that eventually developed were charged in the year the business was written, many of them would have had negative net worth.? As it was, most of them suffered sub-par profitability, losing money on the insurance, and making a little more than that on their investments.

But they survived.? Other insurers cut some corners in the ’90s & ’00s and wrote policies that were putable if their credit was downgraded.? This would supposedly give more protection to those buying insurance or GICs [Guaranteed Investment Contracts] from them.? Instead, the reverse would happen when the downgrade came — there would be an immediate call on cash that could not be met, and the company would be insolvent.? Even if the majority of the liability structure is long, if a significant part of it was short, or could move from long to short, that’s enough to set the company up for a liquidity crisis of its own design.

Credit cycles come and go.? The financial companies in the greatest danger are the ones that have to renew a significant amount of their financing during a crisis.? It’s not as if firms with long liabilities don’t face credit risk; they face credit risk, and sometimes they go insolvent.? But they have the virtue of time, which can heal many wounds, even financial wounds.? If they die, it will be long and drawn out, and they will hold options to influence the reorganization of the firm.? Creditors may be willing to cut a deal if it would accelerate the workout, or, they might be willing to extend the liability further, in exchange for another concession.

In any case, not having to refinance in a crisis makes a financial company immune from the crisis, leaving aside the regulators who may decide the regulated subsidiaries are insolvent.? But, the regulators may decide they have more pressing issues in a crisis from firms that can’t pay all their bills now.

AIG, Prudential & GE Capital

So the Financial Stability Oversight Council [FSOC] has designated AIG, Prudential & GE Capital as systemically important.? They are certainly big companies in their industries, but are they 1) likely to be insolvent during a credit crisis, and 2) does the failure of any one of them affect the solvency of other financial firms?

That might be true for GE Capital.? They certainly still borrow enough enough in the commercial paper market, though not as much as they used to.? If GE Capital failed, a lot of money market funds would break the buck.

AIG?? The current CEO says he doesn’t mind being being systemically important.? Still, Financial Products is considerably smaller than it was before the crisis, they aren’t doing the same foolish things in securities lending that they were prior to the crisis, and they don’t have much short-term debt at all.? The liabilities of AIG as a whole are relatively long.? And even if AIG were to go down, we shouldn’t care that much, because the regulated subsidiaries would still be solvent.? Financial holding companies are by their nature risky, and regulators should not care if they go bust.

But Prudential?? There’s little short term debt, and future maturities are piddling on long term debt.? If the holding company failed, I can’t imagine that the creditors would lose much on the $27B of debt, nor would it cause a chain reaction among other financial companies.

I feel the same way about Metlife; both companies have long liabilities, and would have little difficulty with financing their way through a crisis.? Just slow down business, and free cash appears in the subsidiaries.

I can make a case that of these four, only GE Capital poses any systemic risk, though I would have to do more work on AIG Financial Products to be sure.? But what the selection of companies says to me was it was mostly a function of size, and maybe complexity.? Crises occur because a large number of financial companies finance long-dated assets with short-dated borrowings.? I think the FSOC would have done better to look at all of the ways short-term finance makes its way into financial companies, and then stress test the ability to withstand a liquidity shock.

My belief is that if you did that, almost no insurers would be on such a list; the levels of stress testing already required by the states exceed what FSOC is doing.

Another Lousy Promoted Stock

Posted on 3 June 2013 by David Merkel

Time for the promoted penny stock scoreboard:

Ticker	Date of Article	Price @ Article	Price @ 6/3/13	Decline	Annualized	Splits
GTXO	5/27/2008	2.45	0.013	-99.5%	-64.7%
BONZ	10/22/2009	0.35	0.003	-99.1%	-72.7%
BONU	10/22/2009	0.89	0.012	-98.7%	-70.0%
UTOG	3/30/2011	1.55	0.005	-99.7%	-92.8%
OBJE	4/29/2011	116.00	0.630	-99.5%	-91.7%	1:40
LSTG	10/5/2011	1.12	0.033	-97.1%	-88.1%
AERN	10/5/2011	0.0770	0.0002	-99.7%	-97.2%
IRYS	3/15/2012	0.261	0.003	-98.9%	-97.4%
NVMN	3/22/2012	1.47	0.090	-93.9%	-90.3%
STVF	3/28/2012	3.24	0.380	-88.3%	-83.7%
CRCL	5/1/2012	2.22	0.072	-96.8%	-95.7%
ORYN	5/30/2012	0.93	0.150	-83.9%	-83.6%
BRFH	5/30/2012	1.16	0.300	-74.1%	-73.8%
LUXR	6/12/2012	1.59	0.023	-98.6%	-98.7%
IMSC	7/9/2012	1.5	0.990	-34.0%	-37.0%
DIDG	7/18/2012	0.65	0.073	-88.8%	-91.8%
GRPH	11/30/2012	0.8715	0.200	-77.0%	-94.5%
IMNG	12/4/2012	0.76	0.195	-74.3%	-93.6%
ECAU	1/24/2013	1.42	0.440	-69.0%	-96.3%

	6/3/2013		Median	-96.8%	-91.7%

Tonight’s loser-in-waiting is Dephasium Corp [DPHS], which surged to a high of 59 cents today, probably off of the promotion of the stock, and the completion of an acquisition.? Here are my bullet points on why this company will fail:

No earnings
No revenues
Negative tangible book value
Acquires an asset of dubious value.
Formerly known as Expertelligence, Inc, Pay Mobile, Inc, & Allied Ventures Holding Corp.? What do you want to be when you grow up?? Sorry, *if* you grow up.
Auditor doubts the the company will continue its existence.
Company has consistently lost money through all of its existence.? Has survived through continual dilution of its stock.
To do the acquisition, they sold stock at six cents a share.? They bought back stock at three cents per share.? Now it trades at nearly 60 cents per share.? That makes no sense at all.

As for the acquisition, let me quote from the article linked above:

Since 2006, Dephasium Ltd. has launched a program of research and development to become the leader in the field of people protection against electromagnetic waves emitted by mobile phones. Dephasium Ltd. has succeeded in developing an Ancilia product that it believes protects up to 98% of electromagnetic waves issued by cell phones. This conclusion is based upon the results of technology tests administered by Cetecom ICT Services and included in its written report dated August 10, 2009.

Let me get this straight: you have a product that can reduce electromagnetic waves from cell phones, and you are willing to sell it for a piddling 70M shares of this crud company?? Why didn’t you do deals with Samsung, Apple, LG?? If the test is four years old, why don’t you have a big business by now?

The promoter paid $2.7M to advertise Dephasium.? When I googled the promoter and the one paying, I came up with nothing.? The amount paid is more than the value of the company acquired.? The whole thing stinks.

So avoid promoted stocks.? Don’t buy what someone is trying to sell you; buy what you have researched and discovered on your own.

The Rules, Part XLI

Posted on 30 May 2013 by David Merkel

If businesses anticipate a flow of financing, they will depend on it.? Then a diminution or increase in the flow of investable funds will affect markets, even if the flow of investable funds remains positive or negative.

Most of the sayings from the “rules” posts came from things I thought of while managing investment risk 1998-2004.? I think I wrote this one late in 2002, or early 2003.? I’ll apply this three ways — what I would apply this to now, then, and in-between.

Then: the Fed funds rate was below 2%, and the yield curve was steeply sloped.? The corporate bond market had gone through an incredible bust, but almost all the companies that would fail had already failed, and a big rally was just starting.? Banks were still in good shape, with plenty of lending capacity, which was being applied to residential and commercial lending.? The securitization markets functioned and financing was easily available for residential & commercial mortgages, and many types of consumer lending.

In-between (1): Now I’m talking about 2006-7.? Fed funds rate was rising to an eventual 5.5%.? The curve is flat to inverted, and corporate spreads are very tight.? Issuance of low grade paper is rampant, and covenant protections are declining.? Risk is chasing reward, and gaining.? Everything is overlevered.? Any attempts at prudence are financially punished.? That said, the securitization market slows; deal are harder to do.

In-between (2): Now I am talking about late 2008 to early 2009.? Fed Funds had shifted to its current near zero state, but the Fed had not begun playing with the asset side of its balance sheet.? The yield curve was relatively wide but bull flattening.? Nothing was getting done in lending, and credit spreads were as wide as wide can be.? Securitization drops to near zero. Bank lending is non-existent, aside from buying Treasuries on credit provided by the Fed.

Now: The Fed funds rate is still in the gutter, and the Fed dreams that QE will do a lot for the economy.? (It works in theory! Stupid economists.)? Corporate credit spreads are wide, covenant protections are low, and yields relative to intrinsic risk are low.? Securitization markets are functioning at a reduced level, while banks aren’t lending much to the private sector.? Most housing loans are backed by the US government.

So here is the graph:

The point of this piece is to tell you not to look at the level of risky interest rates, but to look at the rate of change in risky interest rates. It tells a lot regarding future prospects of the stock and bond markets.? The rate of change matters a great deal, not the absolute level of rates.

So, the implication is watch for a sustained rise in in high-yield bond yields.? When those yields cross their 10-month moving average, it is time to be gone from risk assets.