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    Senator McConnell’s Dilemma:   To Serve Patients or Investors?

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When evaluating health care investments it is important to analyze the structure of leading drug and medical equipment companies.  A close look indeed reveals a derivative driven system in which private equity and hedge funds increase demand for drug payments by purchasing the rights to the cash flows from key drugs.  Patients are indeed unaware that many of the drugs they consume are now owned in part by private equity investors.

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On November 18, 2008 I gave a presentation to the local chapter of the American Association of Individual Investors (AAII) at the Multnomah Athletic Club here in Portland, Oregon regarding the overall state of the financial markets.  The talk focused on how we arrived where we are and what to look for going forward.  Also included were what I believe to be the six most important regulatory reforms– all of which could be implemented immediately– that would collectively turn around the economy.

aaiitalkatmacnov08

VIEW EXCERPTS FROM AAII PRESENTATION

These could all be passed and implemented in one week, the only missing ingredient being desire.  It is somewhat astonishing how the current solution is focused on providing trillions of taxpayer dollars to various failed institutions when, if the objective is increased market confidence, these measures can be implemented with little or no cost.  They are:

1)  Requirement that hedge and private equity firms register with the SEC and disclose their top 25 holdings, top 25 sources of funding  and key accounting policies on a quarterly basis.

2)  Expanded oversight of bond rating agencies and requirement that Warren Buffett and other investors who do significant business with these rating agencies divest themselves of equity positions in the same rating agencies.  Buffett is currently Moody’s largest shareholder.

3)  Provide the SEC with oversight of public pensions, now the nation’s largest investment pools.  They currently have no jurisdiction or oversight over such funds, which is simply astonishing given their growth and related impact on the market.

4)  Expanded oversight of proxy firms and development of new competitors in this crucial area.  Currently one firm, Institutional Shareholder Services (ISS), has a monopoly over the market.  ISS is owned by Risk Metrics, a company that recently went public, whose primary owners are unregulated hedge funds.  It is unthinkable that unregulated hedge funds would hold the levers over the most important entity with respect to corporate governance, the entity that votes key corporate resolutions for many leading fund managers regarding mergers, executive compensation, etc.

5) Stock option accounting must be standardized and based upon values captured when such options are exercised rather than using arcane math formulas and related assumptions.  This is simple but has been bitterly fought against by the technology industry, most notably John Chambers of Cisco Systems.  Microsoft has provided the leadership when it terminated its stock option program in 2003, it now provides restricted stock that vests 20 percent each year and whose cost is fully accounted for.

6)  Reform the tax code to prohibit net operating losses (nol’s) from being aggregated and used to purchase profitable companies and avoid taxation.  Such losses should be amortized over 15 years, as is the case when profitable companies purchase other companies with operating losses.  Such amortization was created when a loophole was closed in the 1980’s due to a public outcry, the closure was led by then Republican Senate Finance Chairman Bob Packwood of Oregon.  Packwood and others never conceived that the loophole would be worked in reverse to escape the reform, that is someone aggregating losses and rolling in profitable companies.  Closing this loophole will slow down mergers that make no economic sense and preserve millions of jobs that would otherwise be lost for no sound economic reason other than a few managers leveraging growth in their stock options for short term gain.

Summary:  These are all administrative rules that can be changed next week.  Again, the only missing ingredient is desire.  Please pass this along to any policy makers who might be interested. A VIDEO with excerpts from the talk to the AAII can also be accessed on YouTube by selecting the picture link above, or by searching for “Parish Speaking.”

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This week Bloomberg disclosed that Warren Buffett, the man who has called derivatives a weapon of mass destruction, has himself afterall leveraged his fund Berkshire Hathaway by making a $40 billion bet in derivatives.

Little known to most investors is that Buffett’s primary source of revenue is his 50 insurance companies, including General RE, his company in which top executives are going to jail for accounting fraud associated with transactions involving AIG. The derivaties revelation was accompanied by a sharp drop in the fund price and the downgrading of Berkshire Hathaway bonds.

It is probably also time that Buffett divest himself of Moody’s, he is the bond rating company’s largest shareholder.  Moody’s played the key role in the subprime mortgage debacle and later claimed that it mistakenly overrated subprime debt due to a computer error.

It has been a tough month for Buffett in which the old expression “walk the walk” comes to mind.

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On Friday President Elect Obama designated Tim Geithner to be the next Treasury Secretary and the stock market rose roughly 5 percent in minutes.  Clearly, this was former Federal Reserve Chairman Paul Volcker’s choice and once again demonstrates Volcker’s influence as a beacon of integrity and competence.  It also highlights Obama’s good judgement by seeking out and relying on the best advice, i.e. Volcker.

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Geithner, top right, is a brilliant choice for many reasons, including the notion that he is a career public servant rather than just another investment banker seeking to expand their Rolodex prior to returning to Wall Street,

Equally important was the decision to safely distance Larry Summers, designated to lead the Council of Economic Advisors,  from the key operational decisions that require the competence and grounding of someone like Geithner.  Also critical was to exclude former Treasury Secretary Rubin, known as the Godfather of hedge funds within the industry.

Yet to be made is the critical decision regarding who will be the next Chairman of the Securities and Exchange Commission (SEC), a role only second in importance to the Treasury Secretary.  What is clearly needed is an aggressive regulator focused upon restoring investor confidence.

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One century ago Republican Theodore Roosevelt was elected president and instituted sweeping changes in government, including the establishment of an estate tax and the national park system.  What followed was an economic boom that lasted for years. Roosevelt knew the importance of circulating wealth in order to revitalize the economy by investing in key infrastructure, including the public education system.

Today fierce battle lines are drawn over whether or not the estate tax should be repealed.  On one side are Bill Gates Jr., Grover Norquist and the Wall Mart heirs and on the other side are Bill Gates Sr. and Chuck Collins.  This is certainly not a case of “like father like son.”

While Bill Gates Sr. has co-penned a book with Chuck Collins calling for increased exemptions but not abolishment of the estate tax, Bill Gates Jr. has been the prime funder of Grover Norquist as Norquist tours the country relentlessly advocating a complete repeal of the tax.  Like Bill Gates Sr., I believe the exemption should be raised to $5 million yet do not support a repeal.

I met Grover Norquist, the nation’s most ardent anti-tax advocate, here in Portland some years ago and was amazed at his persuasive skills, and also his ability to bend facts. When I asked Norquist what he would think if I told him Microsoft made more than $10 billion in one year without paying a penny of federal income tax he replied, good for them.

Norquist seems oblivious to the growing acknowledgment that tax equity or fairness is essential to healthy capitalism.  Even the Howard Jarvis tax institute, founded by his mentor, publicly stated that there were serious fairness issues related to Microsoft’s scheme.

Also participating in the debate is Warren Buffet, who like Bill Gates Sr. opposes any repeal of the estate tax, saying:

“We have come closer to a true meritocracy than anywhere else
around the world.  You have mobility so people with talents can be
put to the best use.  Without the estate tax, you in effect will have
an aristocracy of wealth, which means you pass down the ability to
command the resources of the nation based on heredity rather than merit.”                                                     [NYT, 2/14/01]

But Warren Buffet, like the younger Gates, has also been able to sell vast holdings within the structure of his foundation, thereby avoiding all taxes.  The Bill and Melinda Gates Foundation has sold all of its Microsoft shares, not even keeping 10% out of loyalty to the company’s employees.  Of course not a penny of tax was paid on any of these sales and today the Gates Foundation aggressively invests in activities ranging from private equity to currency speculations with all gains completely shielded from any tax consequence.

One simple reform to the system would be to allow tax exempt income status to foundations and endowments only for that portion of their investments invested in US government securities.  All other investments would be taxed at normal capital gain rates.  Perhaps this would help to stabilize the markets and eliminate the excessive risk-taking and speculation many of these tax exempt entities are engaged in, knowing they would have no tax liability on gains.

As the policy debates rage on regarding changes to the tax law, let’s hope that overall fairness has a strong seat at the table, whatever the outcome.

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For several years now I have recommended adding short term Canadian Treasury notes to client portfolios, beginning when the Canadian dollar was roughly 62 cents to the US dollar.  The last of these positions mature in 2008, including those that already matured in July and another group set to mature in December.

Earlier this year the Canadian dollar peaked at 102 and today it sits at 82, implying a decline of 20 percent.  The Australian dollar has by comparison dropped more than 30 percent and the euro has declined 18 percent.  For quality foreign fixed income diversification I have prefered Canada with the notion that Australia is riding a commodity boom yet poorly manages its national finances and the euro is simply being sustained from new countries being added to the euro trading zone.

The question becomes, why the drop in the Canadian dollar when Canada is in a stellar financial postition compared to the US and what does this say about the US stock market.

Canada has consistently run budget surpluses and maintained a strong financial house.  This drop could indeed be rooted in investment funds cashing in these Canadian bonds in order to meet redemptions.  Since highly liquid they are easy to sell.

If indeed funds are selling a high quality sound government security like Canadian Treasuries, a country with much stronger financial footing than the United States, it would also seem apparent that the challenges facing banks and other globally diversified investors could be much greater than anticipated.  This could be particularly true of hedge and private equity funds given the likelihood that large parts of their portfolios are not liquid at the time being.  Current regulations do not require such funds to file reports with the SEC detailing their holdings and their current market values.

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Today is Columbus day, a day that celebrates Columbus discovering America.  Perhaps it is ironic that over the weekend America discovered Europe when it comes to guidance in dealing with our financial crisis.  The answer to the crisis is not to have the Treasury purchase vast amounts of worthless securities from troubled banks but rather to invest in non-dilluting bank stock to help weakened banks re-capitalize.

Thus far it appears that Paulson is still lost at sea because he is advocating purchasing preferred shares, which if done, need to pay interest, be convertible to common and also non-dilluting.  Non-dilluting means that if top execs issue more shares and the govt takes a 25 percent stake, the govt gets 25 percent of all new shares.  Absent this the stock market will clearly plunge again due to becoming overcome with exhaustion at the abject incompetence of Treasury Secretary Paulson.

Secretary Paulson and Christopher Columbus

Secretary Paulson and Christopher Columbus

Treasury Secretary Paulson has handled this crisis about as well as Michael Brown handled the Katrina hurricane in New Orleans.

Paulson began with the audacity of proposing a $700 billion bailout for his wall street pals with the stipulation that none of the $700 billion spent by the Treasury would be subject to any oversight or could be challenged in a court of law.

He then supported allowing his former firm Goldman Sachs to convert to a traditional bank with FDIC insured deposits, positioning it to unload worthless securities on the Treasury and then go out and prey on weakened regional banks.  Goldman Sachs, a key architect of this debacle, should be allowed to fail, that is simply how the market should work.

Even worse, Paulson then designated a 35 year old Goldman Sachs associate, Neil Kashkari. a trained mechanical engineer with little real banking experience, to be in charge of the program.  Paulson doesn’t seem to even now realize that it was indeed “financial engineering”  that got us into this mess. Products should be engineered, not finance.  Reading about this person’s engineering experience working with satellites is interesting and perhaps that is where he should be, not at the Treasury.

Neel Kashkari, the U.S. Treasury’s interim assistant secretary for financial stability.

Simply put, Paulson has attempted to make the Treasury department into the equivalent of a financially engineered speculative hedge fund able to engage in a vast amount of money laundering for his Wall Street associates at hedge and private equity firms.

Paulson still refuses to openly advocate that hedge funds and private equity firms register with the SEC and dislcose their top 25 holdings and investors on a quarterly basis.  Given that these firms primary source of funding is tax exempt organizations such as college endowments and public pensions, the government via the IRS tax exemption status clearly has the authority to demand such disclosure.

One guy Paulson should be listening to is Paul Krugman who just this week was awarded the Nobel Prize in Economics. Krugman has been a strong critic of the current administrations economic policies.  Although an excellent economist, even Krugman still doesn’t quite see the critical need for hedge and private equity firms to register with the SEC.  People are listening Paul and you are reading this blog and so please write the column 🙂

Footnote: The day following this post Paul Krugman wrote the following column in the NY Times. Although a fine piece, once again there was no mention of hedge funds registering with the SEC.

http://www.nytimes.com/2008/10/13/opinion/13krugman.html

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