In the early 1990s, when The Lamb first began trading, his boss gave him a piece of advice that he has kept in the forefront of his mind ever since:  hope is not a hedge.  The message was simple — if you want to protect a position, then take specific action.  Don’t just hope and pray that things will work out — they usually don’t.

As has been mentioned ad infinitum by the ubiquitous talking heads, today is a historic day for the United States.  A new administration takes the reins of a shaky economy and an equally optimistic constituency.  Comparisons of Barack Obama to FDR and Ronald Reagan have been tossed about as if to signify that all is about to be right in the world.

But despite revisionist history, let us recall that economic difficulties continued or worsened during the first few years of each of the above two administrations.  In fact, economic conditions deteriorated significantly during FDR’s second term in office as Americans came to realize that his alphabet soup public works programs were an ineffectual short-term bandaid for a lethal long-term wound.

Regardless of your political affiliation in general or opinion of Obama specifically, we are all rooting for this administration’s success.  The multi-trillion dollar question, however, is what steps will be taken and, more importantly, what will be the ramifications?

Will we have tax cuts (individual and corporate) or tax increases?  Increased government spending or less?  (OK, I think we all know the answer to that one).  What will the Federal Reserve and the Treasury Department do if/when the dollar begins to slide as short-term interest rates remain near zero while budget deficits and the cost of entitlement programs soar?  Remember, the Fed can control either the price or the supply of money — not both.

As we leave a trying 2008 and enter a (perhaps) riskier 2009, take the time to review your finances.  Remember The Lamb’s Rule #2 — Know and understand what you own, and what you owe.  Determine what can hurt you and actively take steps to protect yourself.  Don’t look back a year from now and regret that you had too much money in equities, inadequate protection from higher interest rates or a weaker dollar, or too much/little fixed-income credit exposure.

Remember, hope is not a hedge.

Last November, The Lamb wrote that Uncle Sam should eschew saving General Motors.  He argued that the attempt would be tantamount to keeping alive a terminal patient, with the suffering borne by the American taxpayer.

Fast forward nearly two months.  While The Lamb’s opinion on rescuing GM hasn’t changed, the status of the company’s finances has.  Last week, GM “received $4 billion in initial rescue loans from the U.S. Treasury to help it avoid collapse.”  Many more billions of dollars in loans and other financial assistance is likely forthcoming.  As the Treasury said last week in explaining its current and future assistance to the auto industry (via Bloomberg.com):

“Treasury may consider, among other things, the importance of the institution to production by, or financing of, the American automotive industry.”  The government will weigh “whether a major disruption of the institution’s operations would likely have a materially adverse effect on employment and thereby produce negative spillover effects on economic performance” or on credit markets.

Well, if that doesn’t telegraph that more aid to General Motors is in the cards, The Lamb doesn’t know what does; add to this a newly-inaugurated President Obama’s likely aversion to having one of the most iconic American companies go toes-up on his watch, and you have the makings of an open-ended rescue program.

Just as in the case of the AIG bailout, which carried an initial $85 billion price tag, Uncle Sam has a nasty habit of throwing good money after old money.  He hates to take a loss, especially one that would receive such loud press coverage.  Rather than lose a few billion of taxpayer dollars, he habitually continues to bolster old investments with new money.  With AIG, for instance, over $67 billion (now a total of $152 billion, if you’re keeping score at home) has thus far been promised to the beleagured insurer to protect/bolster/insure the original $85 billion.

Now recall last month that The Lamb advocated investing money in certain institutions that had received money from Uncle Sam in return for preferred stock.  The idea is that owning senior debt of companies that had issued preferred stock to the government was a good risk/reward trade in that Uncle Sam could not recoup any of his principal unless and until you received yours, as senior debt is ahead of preferred stock in a company’s capital structure.

As The Lamb said then and still fervently believes today, “Uncle Sam is gonna get his money back.  You will, too.”

The loan(s) that Uncle Sam provides GM will, in all likelihood, be senior to any senior debt of GM and will not obviate the risk of GM’s defaulting on its senior debt.  However, The Lamb believes that there is a better than decent chance, similar to that of the AIG situation, that Uncle Sam will be loathe to let a company to which it has lent billions of dollars go bankrupt.

Now, it is certainly possible that there will eventually be a (coerced) debt-for-equity exchange, a shotgun merger, or even a pre-packaged bankruptcy.  Each of these could easily result in a significant haircut for GM bondholders.  However, the recovery value for GM debt is likely to be around 10 cents on the dollar, somewhat mitigating any loss.  GM bonds are unquestionably very risky — both Moody’s and S&P have them rated well into the nether regions of junk status.

However, with all this in mind, one interesting and admittedly very risky investment idea is to purchase relatively short-dated senior debt of General Motors.  Though only for investors with the greatest predilection for pushing the risk/reward envelope, 2-year maturity senior debt of GM currently carries a tantalizing yield-to-maturity of over 100%.  Translation:  if the bonds mature at par (100 cents on the dollar), an investor will quadruple his money over a two-year period, including coupon payments.

The GM 7.20s of 1-15-2011 are currently (as of Friday) priced at a dollar price of 25.03, according to the bond market’s Financial Industry Regulatory Authority’s (FINRA) pricing service.  This equates to a yield of 100.46%, and is a low enough dollar price that even a 10 cent recovery value brought about by bankruptcy will not completely wipe out the investment.

As a final caveat, before making this or any other investment, The Lamb strongly urges you to repeat Rule #2 at least three times while standing in front of a mirror:  “Know and understand what you own.”

Disclosure:  The Lamb currently has a small amount of the above-mentioned GM 7.20s tucked neatly into a dark little corner of his portfolio.

“Seek advice, but use your own common sense.”  This Yiddish proverb seems particularly apropos in the wake of the ongoing Bernard Madoff scandal.  For years, even decades, investors in Madoff-associated funds basked not only in the comfort of 10%-plus returns, but also in an incredible lack of variance in those returns.  All this despite a market that endured several years of roller-coaster-like ups and downs.

The list of investors in Madoff’s funds reads like a “who’s who” of banks, funds, foundations, and ultra-wealthy individuals.  Many (if not most) of these investors are far smarter than The Lamb would claim to be.  However, where was their due diligence?  Where was their questioning, their skepticism?  Where was their interrogation:  “How are you able to do this?”

When people with the gall to question or challenge his returns did ask him for explanations, most were greeted with the refrain, “It’s too complicated, you wouldn’t understand.”  While that may have been true (doubtbul, but possible), The Lamb prefers to cling tightly to Rule #2:  “Know and understand what you own (and what you owe).”  If it’s too complicated for The Lamb to understand, he passes.

(Madoff did respond to more persistent inquiry by saying that he employed a “split-strike conversion strategy.”  This fancy sounding tactic involves selling out-of-the-money call options on one’s positions to generate extra income.  It also utilizes some of this option premia to purchase downside protection in the form of out-of-the-money put options.  However, even with this modus operandi, it would be nearly impossible to generate the consistently high returns that Madoff claimed.)

A few months ago, The Lamb had a significant portion of his cash position invested in GE Interest Plus (GEIP).  After reading the prospectus, he believed that this investment, described on the GEIP website as “a AAA-rated unsecured and unsubordinated debt obligation of GECC (General Electric Capital Corporation),” was simply a retail-targeted short-term IOU of GECC, one of the largest and historically safest companies in the world.  In other words, this was tantamount to floating-rate (the rate would change as short-term market interest rates changed) commercial paper.  The Lamb invested.

However, several months ago as the financial crisis worsened and short-term rates almost universally fell, the yield on The Lamb’s GE Interest Plus account actually rose.  In fact, the rate was now quoted at a level far in excess of what GECC was offering on its institutional commercial paper.  Something was off.  Either there was a problem with something related to GE Interest Plus or The Lamb was too dumb to figure out why he was earning such a (relatively) high rate.  He needed answers.

The Lamb exchanged several emails and phone calls with GE Interest Plus, but was graced only with vague and seemingly pre-formed responses.  Now, to be clear, The Lamb is not insinuating that there was or is anything untoward occuring at any entity of General Electric.  (In fact, he still owns a sociable-sized position in senior unsecureed GECC floating-rate notes maturing in 2012).  However, without a satisfactory explanation, he did not (and still does not) feel comfortable having anything more than a token amount of money invested in GEIP, and has yanked over 99% of his investment.

————————————————–

Several years ago, The Lamb was charged with investing his grandmother’s savings.  Thankfully, she had an ample nest egg and really didn’t need anything except for the safe return of her principal in order to pay for her lifestyle.  That lifestyle consisted almost entirely of having lunch at “The Club,” playing Mahjong with the girls, and making the 40-minute drive to the (legal) casinos in South Florida for some Hold ‘Em poker. 

Therefore, The Lamb kept all of her money in cash, yielding next to nothing.  Her returns would be minimal, but she would be able to play Mahjong and poker for decades, and could lunch at The Club whenever she desired, sending back all the too-fishy crab cakes and cold coffee she wanted to.

The Lamb’s Rule #1 was paramount here:  “With “can’t lose” money, return on capital is far less important than return OF capital.”

Despite her advancing age, Grandma Lamb maintained a competitive streak.  Besides wanting to win at Mahjong and poker, she wanted to be sure that she was earning all she could on her life savings.  Many of her friends at The Club had been investing for years with a nice man from New York who had provided them with returns north of 10% — “Guaranteed!” 

She shrugged off as cynical her obstinate grandson’s arguments that guaranteed 10% returns were either impossible, illegal, or both.  All she knew was that her friends were earning 10%, and she was stuck with only a tiny fraction of that return.  But as the years went on, she (thankfully) fixated more on her poker game and less on her bank statement’s puny investment performance.  Eventually, she even learned to tune out her friends’ boasts of their lucrative investments with that nice man from New York; her money stayed in cash.

Grandma Lamb passed away on Halloween evening, 2007.  She played her final game of poker just one week before she died — a joyful five-hour session she shared with her grandson.  Despite years of low returns on her money, Grandma Lamb still had more than enough of it to cover her grandson’s $45 loss that day.

Oh, and that nice man from New York?  You may have heard of him.  His name is Bernie Madoff.

The Lamb is cynical by nature.  He is a paid-up subscriber to the axioms “If it sounds too good to be true, it probably is,” and “Where there’s smoke, there’s arson.”

Recently, a friend of The Lamb, Adam (name changed to protect the imprudent), told him about a new website called OneSeason.com.  Adam is a willing, though very suspicious, participant in the OneSeason market.  Essentially, this site allows “investors” to buy and sell shares in their favorite players and teams from the world of sports.  There are both primary and secondary markets.

In the primary market, OneSeason conducts initial public offerings (IPOs) of shares for both teams and players (with a price set at $5 per share) via an allocation algorithm.  These shares are then traded in the secondary market, splitting if/when the price reaches $20 per share.  The company makes money by charging commissions of 5% on IPOs and 1% on secondary trades.  Presumably, fixed and variable costs are de minimus. 

Now for the fun part.  Unlike traditional shares of company stock which entitle the holder to a fractional ownership of that company’s net profits, holders of OneSeason shares simply own the bragging rights to a given player or team.  Unfortunately, bragging rights, much like gold and vacant land, are not positive carry investments.  Then again, land and gold are both tangible assets and offer at least the potential of capital appreciation.

Of course, OneSeason shares can go up in value.  An investor simply has to find someone to pay a higher price than he paid — the so-called “greater fool theory.”  The Lamb certainly feels that OneSeason participants are entitled to purchase shares as they wish – (The Lamb’s Rule #5 — “You pay your money, you take your choice.”)  However, he feels that OneSeason has essentially created a somewhat mitigated pyramid scheme.  This “venture” differs only slightly from the early 20th century Ponzi Scheme. 

Charles Ponzi's Mugshot

The product (service?) OneSeason sells has no intrinsic value save for the aforementioned bragging rights of player/team cyber-ownership.  This may be a good time for potential OneSeason participants to repeat to themselves The Lamb’s Rule #2 — “Know and understand what you own.”

One may ask how this is any different from owning a baseball card or even a work of art.  The difference is that in owning one of these two types of positional goods, an investor has possession of a tangible item, and more importantly, one which is of finite supply– 

Pablo Picasso is not going to be composing many more paintings, and the American Tobacco Company threw away the mold for the T206 Honus Wagner baseball card nearly a century ago.

As amazing as it seems to The Lamb that this market exists, more incredible still is that it has actually spawned websites for OneSeason investors (again, the term “investors” is used extremely loosely here) to exchange opinions and information about share prices of players and teams, much like websites devoted to fantasy football/baseball enthusiasts.  Sites like OneSeasonNation.com and OneSeasonTrader.com garner far more hits than does your editor’s humble corner of the blogosphere.

Trade shares at OneSeason.com if you wish.  But keep The Lamb’s Rule #4 (An asset is only worth what someone else is ready, willing, and able to pay for it) safely in the front of your mind. 

Right now, Adam is wishing he had remembered it…

It is said that capitalism without losses is like religion without hell.  According to a 2003 Harris Interactive poll, 69% of U.S. adults believe in a repository of eternal punishment and damnation.  But if Uncle Sam has his way, no one will be forced to visit or remain there.

The FDIC recently expanded its insurance for eligible bank accounts from $100,000 to as much as $500,000.  In fact, a married couple can now have up to $1 million insured at each FDIC-insured depository institution — $250,000 for each spouse’s individual account, plus $500,000 held in a joint account.

Want even more coverage?  No problem.  The FDIC now also insures trust accounts for amounts well into the millions.  And if you’re fortunate enough that you need even more coverage, all you have to do is start the process all over again at a different bank!

Why does The Lamb see this as a problem?  Isn’t more insurance good for everyone?

For everyone?  No.  The FDIC is not some amorphous entity that magically provides funds to make whole depositors at failed banks.  The FDIC is us.  We’re the insurer.  Or, to put it another way, those that don’t have funds that go bad effectively pay those that do.  

Now, you may argue that the FDIC is funded by insurance premiums that banks pay on deposits.  While that is technically true, the FDIC has only a fraction of the funds it will need to bail out depositors of the thousands of banks expected to fail in the coming year or two.  In fact, the recent “bailout bill” (The Lamb forgets what we’re officially calling it now) allows the FDIC to borrow UNLIMITED amounts of money from the U.S. Treasury (read: us) to help it maintain solvency.

All of this is IN ADDITION to Uncle Sam’s recent insuring of trillions of dollars of money market fund assets (see the post 2 + a + 7 = 50,000,000,000).  Our government is creating a system in which failure is all but impossible.  While this may look good in theory, it generates terrible moral hazards. 

The Lamb believes that investors should be free to invest wherever they please.  However, if an investment sours, those who made safer (and lower yielding) ones should not be forced to ride to the rescue.  There simply must be negative repercussions for poor investment decisions.

The preceding is exemplary of The Lamb’s Rule #2:  Know and understand what you own, and what you owe.

If investors want investments with guaranteed principal repayment, great.  There are trillions of dollars of them available for purchase.  They’re called United States Treasury bills, notes, bonds, and inflation-protected securities.  Investing in them is easy (see the post Safety and Soundness) and can be done by going to the Treasury Direct website.

Are the nominal yields on Treasuries (particularly T-bills) generally lower than those of money market funds and bank deposits?  Yes.  And they should be, given the full-faith-and-credit nature of the investment. 

Put your money wherever you want.  Take whatever risks you want.  Feel free to stretch for that last basis point.  But if things go wrong, don’t take others to hell with you.  Real or not, it doesn’t seem like a very nice place to be.

The Lamb’s beautiful and brilliant wife scored 770 out of a possible 800 (99th percentile) on the GMAT, the standard entrance exam for aspiring Business School students.  While she would tell you that the above equation solves to:
a = 49,999,999,991, The Lamb sees a deeper meaning.

Money market funds, also referred to as 2(a)7 funds because of the SEC rule number which dictates what investments they can make, have traditionally been seen as one of the safest investments available.  Typically, all money market funds must keep investment maturities to a maximum of 397 days and their overall weighted average maturity must be less than or equal to 90 days.

Following fears of a run on the nation’s money market funds, the Treasury announced today that it will utilize all $50 billion of the Exchange Stabilization Fund (ESF) to ensure that over $2 trillion worth of money market funds does not decline in value, known as “breaking the buck.”  The primary role of the ESF is to maintain the stability of the United States dollar.  This has become even more critical since the country was taken off the gold standard in the 1970’s and now relies solely on “fiat” money.  While one would assume that Congress could authorize the replenishment of the ESF, The Lamb believes that this prospective insuring of money market funds is a dangerous move that risks moral hazard if not accompanied by new limits on money funds’ investments.  If money funds offer large institutional accounts Uncle Sam’s good name along with yields higher than what they can get from commercial bank deposits whose FDIC insurance is limited to just $100,000, where do you think they are going to put their money?  Not in commercial banks.  Sudden outflows from banks could cause a liquidity squeeze that dwarfs that experienced by the investment banks and other funds this past week.

While The Lamb noted in his “Fannie, Freddie, and Sam” post from early last week that a broad failure of money market funds “would all but freeze short-term funding for most global financial institutions” he is nevertheless aghast at this recently proposed bailout.  This is not simply the indemnification from losses on debt implicitly backed by the federal government.  No, no.  This is forcing all taxpayers to make up for any loss of principal on investments that individuals and institutions voluntarily make.  These investors know, or at the very least should know, what assets are held in the funds in which they invested– the information is freely available from any public 2(a)7 fund.  Investors should refer to The Lamb’s Rule #2– Know and understand what you own.

Under this new proposal, what’s to stop every money fund in this country from pushing the duration and credit envelopes in the search for higher yields and greater incentive fees?  Heads, they win; tails, no one loses– except of course for you, The Lamb, and every other taxpayer.

Make no mistake, The Lamb believes that if we had had a run on money funds, as it appeared yesterday, it could have been the beginning of the end.  What’s a better solution?  If the Federal Government decides to insure money market funds because it fears a run and its disastrous ramifications, fine.  But how about getting paid significantly (not just a few basis points) for providing the insurance?  Banks are charged for the privilege of deposit insurance, so why shouldn’t money funds be charged, and charged commensurately with the risk they take?  For the privilege of FDIC insurance, Uncle Sam requires banks to pay a fee, keep adequate reserves on hand, submit to examinations, and undertake other expensive regulatory tasks.  Due to their structure, money funds that want this new insurance should be required, among other things, to take less risk.  For starters, how about forcing them to decrease their average maturity from a maximum of 90 days to just 30 days?  Yes, this will decrease yields for investors.  But if investors want/need to have their investments insured by Uncle Sam, then make them pay for the privilege.  If they don’t want to pay for it, then let them invest elsewhere.

*UPDATE*

On 9/21/08 from bloomberg.com:

The Treasury said in a statement late yesterday it would limit its $50 billion plan for insuring money-market funds to those held by investors as of Sept. 19, excluding any subsequent contributions.

The American Bankers’ Association, which had expressed concern about the plan last week, praised the move, saying it would eliminate an incentive for savers to shift out of bank accounts into money-market funds. The Treasury put no limit on the money-market fund insurance, while the Federal Deposit Insurance Corp. protects bank deposits up to $100,000.

“If all money market mutual funds had been included with the government guarantee moving forward, this proposal would have threatened to take money out of local FDIC-insured banks,” Edward Yingling, president of the ABA in Washington, said in a statement.