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	RANDOM THOUGHTS

3/18/08 - Time for the BS to stop…and for BS to go on…

The first BS is the completely out of control financial markets environment where apparently anything can happen and anything can be done. The “anything can be done” part occurred over the last week when “rumors” of illiquidity at a major investment bank became a self-fulfilling prophecy. Behavior usually shown by cockroaches when the lights are turned on was instead displayed by major customers and counterparties of the major investment bank. The resulting “run on the bank” due to the rumors left the bank with no liquidity. As we all know by now, a major financial institution was essentially driven into virtual bankruptcy by such rumors. Kudos to the scummy hedge funds who put on a huge short position in Bear Stearns stock and then spread the rumors.

I am sure that Bear Stearns does have a lot of illiquid and hard to value assets but that is certainly also true of many other major financial institutions who have already announced write-offs in the tens of billions. Investment bank assets are also not supportive by a lot of equity in case that fact is also not widely appreciated. Bear Stearns most recent 10-K reported an equity to assets ratio of 2.98 percent. As Carlyle Capital found out in the last week, when your balance sheet is levered 30-to-1, your assets only have to drop three percent in value and you have no more equity. The game works when there is liquidity and functioning credit markets to support such leverage but when rumors spread, credit is no longer available.

In case anyone thinks that Bear Stearns is an exception with leverage, it is not. Goldman Sachs and Lehman Brothers reported earnings today that were better than expected and so there are some other real world data points about whether other major investment banks are likely to go broke. Although Goldman Sachs did not report a balance sheet with its earnings press release, its 10-K for the year ending November 2007 showed an equity to assets ratio of 3.82 percent. That may sound a lot higher than Bear Stearns but it still means that their balance sheet is levered 26-to-1, which is not a lot different than Bear Stearns at 33-to-1. Lehman Brothers, whose stock is up 40 percent today after yesterday’s hysterical plunge, reported a leverage ratio in its press release today of 31.7-to-1 – which is virtually identical to Bear Stearns but I guess they are ok to stay in business and don’t have to be sold at some fire sale price due to rumors.

Back to the general topic of BS, however, there is another notable fact about our very difficult equity markets since last summer which is until June 30, 2007, there had been an uptick rule for short sales which originally been implemented to counter the abuses seen in the horrific stock markets of the early 1930s. Although there have been some real events of concern since last summer, the crazed trading and outsized drops in individual stocks relative to both actual fundamentals and valuations that have occurred within individual trading days and over the last eight months suggest that something nasty is going on behind the scenes that regulators choose to ignore.

A prime example of the currently abusive and apparently unregulated environment is one of my mutual fund’s holdings which is Jos. A. Bank Clothiers. Looking at the company’s most recent SEC filing shows that the company has 18.2 million shares outstanding. Reviewing the most recent 13-F reports for the December 2007 quarter shows that institutions report owning 30.7 million shares of the company (neither 30.7 million or 18.2 million are typos). The “reported” short position in the company is 11.0 million shares (which is about 60 percent of the reported outstanding shares), which is also sort of interesting for a debt-free and cash flow positive company but I guess everyone is entitled to their own opinion about things. The actual short position is probably even higher given that brokerage firms, through the arcane aspects of the “settlement” system have somehow created at least an additional 12.5 million shares of this company for institutions to buy from unreported short sales.

If another part of the U.S. Government, the Treasury Department, discovers counterfeiting activity concerning U.S. currency, they will put the counterfeiters in jail. In a very advanced capitalist economy, shares of stock have the same importance as currency, however, but if you counterfeit those at your brokerage firm then you get a bigger bonus and another part of the U.S. Government, the SEC, looks the other way. I am not against short-selling activities as there are a lot of ridiculous companies and stock market anomalies on the upside that warrant appropriate and legitimate short selling activities. Driving companies out of business with rumors and having thousand of employees terminated as a result is not, however, what I regard as a legitimate short selling activity and integrity needs to be restored to our financial markets to prevent such abuses in the future.

Unfortunately our financial markets have been affected by more than internal abuses in the last eight months, however, as another “unregulated” phenomena has had very real effects on both financial institutions and the real economy. This phenomena was the mortgage market bubble where a highly sought after customer was someone with no money, bad credit, and who lied on their loan application. After that, the mortgages then were sold to investment banks, who applied various forms of hocus-pocus to turn them into securities to hoodwink other financial institutions to buy the mortgages. Aside from just buying such securities, however, the perception was that most people will do anything to pay their mortgages so heavy leverage can be applied to portfolios of such stuff.

As has now been seen from SIVs imploding, various hedge funds imploding, and huge writeoffs from other major financial institutions who apparently didn’t understand what they really owned or that they shouldn’t have used so much leverage while owning such securities, maybe the world needs more oversight about such “free market” economic activities. Alan (Rainman) Greenspan is still apparently regarded as some sort of guru by those who have him speak here and there at exorbitant fees to mumble about whatever. He was Fed Chairman, however, while the mortgage business went crazy and I do not understand why, for all of his supposed brilliance and insight, he didn’t draw a line in the sand which said merely: if a customer doesn’t have at least ten percent in cash for the purchase price then a bank can’t issue a mortgage or if a bank is in the home equity line of credit business then a maximum combined loan to value of 90 percent is required for a bank to issue a line of credit. Aside from equity requirements, why another line wasn’t drawn in the sand about the 2/28 products that typically reset 40 percent higher merely two years later (when typical compensation increases are less than five percent a year) is another phenomena that I will never comprehend. Maybe a portion of Alan’s speaking fees can go into the various funds and help programs that now exist to help people avoid foreclosure on their mortgages. In any case, such absurd products and practices unfortunately beg for more oversight of financial institution business practices.

In addition to financial institution business practices apparently needing more oversight, leverage ratios are also endangering the health of what had been the most efficient capital markets in the global economy. As anyone who owns “exotic” securities at this point knows all too well, markets have seized up and are no longer efficient in many respects. A very much underappreciated economic advantage enjoyed for a long time by U.S. companies were the lower capital costs relative to many foreign companies with less efficient capital markets. Most companies, regardless of where they are based have few sustainable advantages on an operating basis – particularly in an increasingly integrated and extremely competitive global economy. The capital costs for U.S. companies were a sustainable advantage, however, but that advantage may be ending given the neglect and lack of oversight that have now severely seized up major portions of U.S. capital markets.

Real companies selling real products and services do not need financial intermediaries with leverage ratios of 30-to-1 when such excessive leverage ratios also threaten the sustainable capital cost advantages that such companies have had. Now that the Fed has opened the spigots to major investment banks during the current liquidity crisis, maybe there should also be a precedent set that such financial institutions also need to de-leverage in line with the requirements for the banks that the Fed is mainly chartered to regulate. Such a result would eventually cut investment bank leverage ratios by approximately 50 percent but since such additional leverage was mainly used to fund speculative assets then the slimmed down balance sheets should have little affect on real world economic activity.

In addition to the de-leveraging of investment banks, another gaping hole is from the huge number of unregulated financial entities who have used all the leverage offered to them by investment banks. Most of such financial entities have survived and only a few have imploded but the day to day effects on financial markets from the crazed daily trading of such speculative financial institutions has also had a seriously deleterious effect on the rational functioning of U.S. financial markets. Adding in the termination of the short sale up-tick requirement and the apparently ability to counterfeit shares of common stock as needed, it is clear to me that much more regulation is required to maintain the orderly, efficient, and fair functioning of financial markets.

Leverage available for unregulated entities are also absurd relative to existing regulations about leverage that apply to individuals. Margin requirement for individual investors at a brokerage firm are 50 percent but leverage ratios for prime brokerage clients can reach 50-to-1, or two percent. If the additional capital available from such leverage was used productively for the overall benefit of the U.S. economy then such practices may be appropriate but when the end result is that it enables 10,000 hedge funds to frenetically churn the relatively limited amount of available securities then the additional capital does not benefit real world economic activity.

Concerning the sheer number of hedge funds, however, maybe another way to raise money for mortgage bailout funds is to sell “hedge fund medallions” the same way that New York City taxi medallions are allocated and limited in number. If hedge fund licenses were limited and sold to the highest bidders then if you think you are really good and have value to add - instead of just mindlessly churning through security after security - then you could bid a lot for one of the limited number of hedge fund licenses and we would probably have much better functioning financial markets.

In summary, overleverage and lack of oversight are a much greater threat to the U.S. economy than the usual suspects such as trade deficits, a weak dollar, a possible recession, and high oil prices. We are apparently still driving our cars and so I guess we are dealing with oil prices. We have had recessions before and apparently lived through them somehow and stocks always went much higher after they were over. The weak dollar has helped contribute to another underappreciated phenomena that suggests the strength of the U.S. economy which is that export growth is now very impressive and so the supposedly uncompetitive U.S. manufacturing sector apparently has products that the world loves to buy after all. The trade deficits are also underappreciated as a sign of strength that our credit is still good outside the U.S. even though we are destroying our own capital markets but in any case, my opinion is that factories overseas need us to keep buying their stuff more than most Americans need to keep buying more stuff.

History in general and economic history more specifically is full of examples of things that people have worried about that have not had any significant effect in subsequent events. The events that change history and alter the course of economic progress are usually unrecognized until they are irreversible. My opinion is that we have not yet reached that state with the Wild West conditions of our current financial markets although we are much closer to a crisis. It is also interesting that there are mixed opinions so far on Ben Bernanke and his leadership through this period. Most of the mixed opinions seem to come from the investment community who always wants more so that the speculative party can continue. Any hint that the world will not be friendly to speculators is met with severe disapproval and financial market tantrums of the sort that one would expect of a six year old who is not getting their way about things.

If anything, given the unregulated and negligent mess left behind by Rainman, Bernanke is doing a great job navigating through the mine field of speculative excesses, illiquid assets, a weakening economy, and some threats from inflation. As the Fed Chairman said the other day, however, when the $30 billion non-recourse credit line from the Fed to J.P. Morgan as a conduit for additional liquidity to Bear Stearns was announced, he was having a busy day. Financial markets probably function a lot better when the Fed Chairman is not having a busy day. Maybe the SEC and other regulatory agencies can care more about the effective functioning of U.S. financial markets to implement or enforce regulations that will restore integrity to what had been the most efficient financial markets in the world. And maybe the other BS, can just get the $30 billion directly from the Fed and continue to operate as a separate entity given that such liquidity is now being made available to other major investment banks from the Fed.

2/6/08 - Moto-roll-ova...

There was a a pretty significant corporate announcement last week that Motorola, the pioneering U.S company in the radio business, was thinking of getting out of the cell phone business, although a cell phone is a radio...

Now I am just a poor money manager and obviously not as sophisticated as the deities that run very large and complex public companies but I am still in sort of a state of shock about that particular announcement. Maybe the internal discussions between the CEO and the CPG (Cell Phone Guy) that led to such a possible course of action might have gone something like this:

CEO: Hey CPG, how's that cell phone business going?

CPG: Tough business boss!

CEO: How's that again? I mean what do we pay you for?

CPG: The whole thing is just impossible to manage...

CEO: What's going on?

CPG: The competitors just keep introducing new phones!

CEO: Damn!

CPG: It's never ending!

CEO: I'1l say! But what are revenues now at this point?

CPG: Only $18 billion and I don't have a clue as to how we make ends meet.

CEO: About that pesky new phone thing, however, what's your development budget?

CPG: Around a billion, give or take...

CEO: Oh, I see...but who else out there is also introducing new phones?

CPG: Nokia, I guess...

CEO: Anyone else?

CPG: Maybe Samsung and Sony Ericsson too.

CEO: What's their deal then with developing those new phones?

CPG: Just to be a pain to us I guess, I mean we are Motorola and you'd think they would show us some respect.

CEO: Wasn't there some start-up too who introduced some sort of phone?

CPG: Oh yeah...those people...but they were just picking the low hanging fruit! And with pretty shady pricing strategies too as they first built up all sorts of hype, duped the first buyers, and then cut the price. We are Motorola, we don't do stuff like that.

CEO: Ohhh...but what are that start-up's phone sales at this point?

CPG: Probably about $6 billion - but they had a big advantage as they didn't have to manage all those engineers that we have while we spend about a billion a year.

CEO: So what are your plans at this point?

CPG: Some guy I saw at a conference said we should just get rid of the whole thing; it would boost shareholder value or something or other.

CEO: I've heard about that too! Ok, whatever, I guess that's the best thing to do - and we can say all kinds of cool things too in the press release such as sharpening our strategic focus, optimizing our resources, efficiently using our capital, and positioning for our future...

As for other parts of this saga, however, the supposed focus on "sharholder value" has unfortunately largely resulted in being pressured to produce "short-term value" so that short-term oriented investors can make a quick pop and go on to the next target. Obviously something is wrong with an operation producing below adequate returns on an $18 billion revenue base but I would hope with more competent management and renewed focus that this business could again be a vibrant and very competitive participant in the cell phone business. It wasn't all that long along that Motorola's last significant new product introduction produced significant market share gains and revenue growth. Giving up on such a business seems pretty senseless - especially with the resources available to renew its growth.

As for members of the investment community supposedly focused on "increasing shareholder value", however, I also sometimes wonder what such "activist" investors are thinking or how much research they are even doing. The prominent saber rattler Carl Icahn has been asking for Board seats while owning only three percent of the shares. Given the length of time Icahn has apparently been involved with this, it would also appear that he is down at least $500 million on his investment.

Given management "rolling over" and being ready to give up on $18 billion in revenues, maybe some outside stimulus would be helpful to offer a new perspective on how to turn around a significant business. With the current activist investor's cumulative loss, however, it appears that he also did not understand the existing business and so maybe a more insightful and longer-term perspective is needed for both investing and U.S. businesses in general. In any case, good luck to you Motorola, I hope you can turn things around and continue your pioneering presence in the electronics business.

The views and research presented on these pages are not intended to be a recommendation of securities to investors. These represent our current views on the industries and companies mentioned, and our opinions are subject to change at any time without notice. We encourage investors in the Polynous Growth Fund to refer to the prospectus for a more complete description on the investment process, expenses and charges associated with the fund.
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