“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.

For anyone interested in an extra safety blanket for your money, The Lamb recommends opening an account directly with the United States Treasury at TreasuryDirect.  With this account, one can purchase U.S. Treasuries at weekly auctions and have them kept at the United States Treasury.  The Lamb has a difficult time thinking of a safer place to put money.  Setting up the account takes less time than bidding on Lehman Brothers memorabilia on eBay.  You link it to your bank account, and then you can purchase and roll bills, notes, bonds, and TIPS, or have the maturing cash put back into the same bank account from which you paid for the original securities.  For those that want safety in addition to FDIC/SIPC, The Lamb suggests looking into this.
 
The Lamb does not believe that we are heading into a 1930’s style depression or financial collapse.  Nor does he believe that there will be a wave of large financial institutions that will fail.  However, there will likely be many smaller institutions that will peek into the abyss and the lack of funding alternatives will push many of them into it. 
 
Do not be under the illusion that if you have funds in a money market fund that they are 100% safe.  First of all, they are likely not insured BY ANYONE, let alone the U.S. government.  The Lamb would venture to guess that if he asked you what the top five holdings were in your money fund, you may not know.  Money market funds, technically 2(a)7 funds, can and do carry risk of principal loss.  Yesterday, for the second time since the 1990’s, a money fund “broke the buck.”  This is a fancy way of saying that investors could only redeem their investments for some fraction of “par.”  This was not just some small fund, it was the Reserve Primary Fund, the oldest money market fund in the U.S., and held over $60 billion in assets just last week.  Investors that took the time to look at the holdings of the Reserve Primary Fund saw that it held over $750 million in Lehman paper and, following Lehman’s weekend bankruptcy, decided to withdraw their money.  The Fund saw more than half of its funds redeemed in the 48 hours prior to its announcement yesterday.
 
FDIC and SIPC insurance, to be sure, are great things.  While you can place money at multiple depository institutions to “get around” the $100,000 per account protection limit, the FDIC may have difficulty covering losses triggered by a tsunami of commercial bank defaults.  Yes, the FDIC has lines to the Treasury, but do you really want to count on not getting a financial “haircut” if the FDIC has to go begging to the feds?  Regarding SIPC, their coverage is a heftier $500,000 (including $100,000 in cash protection) per securities account, but they currently have just over $1 billion in reserves.  I realize that these accounts are supposed to be segregated, but the SIPC does not cover fraud.
 
Some investors are beginning to lose confidence.  Credit default spreads on U.S. Treasuries have widened to roughly 15 bps in 5yrs and 20 bps in 10yrs, both record wides.
 
Losing a portion of one’s investments isn’t the end of the world.  Many of us have been invested in equities and commodities the past few months and have the battle wounds to prove it.  However, when investing cash that he simply can’t afford to lose, an extra 50 or 100 basis points (0.50%-1.00%) just doesn’t matter that much to The Lamb, particularly when viewed on an after-tax basis.   With this money, the most important thing to The Lamb is not his return on capital, it’s the return OF his capital (see The Lamb’s Rule #1).