ACTIONABLE ADVICE FOR FINANCIAL ADVISORS: Newsletters and Commentaries Focused on Investment Strategy

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Watching the daily trading action of the market, it is difficult to slough off the feeling that the powers-that-be are fiddling while Rome burns.  But it is particularly appalling to watch the regulators stand by and allow what can only be considered outright stealing to continue.  The latest manifestation of this is a type of front-running – an activity that is irrefutably illegal –that has been dressed up in the fancy term “latency arbitrage.”  The writer in me has to acknowledge the sheer linguistic beauty of that term, but my admiration gives way to nausea when it turns out that the words describe a process whereby certain fast-moving computer-trading operations simply obtain market data a nanosecond before other traders and then use this data to their advantage.  According to our friend Bill King, “[t]he firms gain that advantage by buying data from stock exchanges and feeding it into supercomputers that calculate stock prices a fraction of a second before most other investors see the numbers.  That lets these traders shave pennies per share from trades, which when multiplied by thousands of trades can earn the firms big profits.” 8 Earlier this year, the SEC and Congress made a lot of brave noises about limiting flash trading and other computer-generated trading strategies that were obviously corrupting the markets, but little seems to have changed.  In this case, it is definitely time to pull out the torches and pitchforks and storm the castle.

“The fault, dear Brutus, lies not in our stars…”

I recently wrote an opinion piece that appeared in the Spanish newspaper El Mundo (I am a bi-monthly Sunday columnist for that publication) in which I wrote the following:

“In a democracy, a country gets the government it
deserves.  Unlike countries that are ruled by non-
democratic means (despite the fact that they hold
elections), democratic societies freely choose their
leaders. The great tragedy of today’s Western
democracies is that voters continue to demand that
their leaders engage in self-destructive economic
policies instead of demanding accountability and
tough choices.  The political systems of the major
Western democracies have become captive to
powerful special-interest lobbies that place their
interests ahead of those of society as a whole.  This
makes it almost impossible to develop sound policies
to deal with complex problems.  The hegemony of
powerful special interest groups also distorts
economic incentives and the directions in which
economies evolve.  The result is that massive
amounts of intellectual and financial capital are
diverted to unproductive uses as society’s most
powerful interest groups fight over the distribution
of wealth rather than focusing their energies on
increasing society’s overall wealth.”

The manner in which financial reform legislation has been effectively neutered by special interests is a testament to the ascendancy of special interests, particularly financial interests, in the United States.  The full story of this is told in Robert Kuttner’s A Presidency in Peril.  But as noted in my essay in El Mundo, how can we expect meaningful reform when the very constituents who would benefit from it do not have the courage to demand it?  A case in point is the recent criticism aimed at Wall Street eminence Byron Wein, who was called on the carpet by clients of his employer The Blackstone Group after daring to speak the truth about public pension benefits.  In a January 5, 2010 webcast (this should be old news, but apparently clients are still upset by what Mr. Wein said), Mr. Wein noted that “the retirement benefits for state workers, really not only in New York, California and New Jersey, but throughout the country, are very generous.  Too generous.  And it is very hard to change that…But I think we have to be more realistic.  We literally can’t afford the benefits we have given our retirees in state and local governments.  And we have to change that.” 

About a month later, Pension & Investments published a letter from Steve Cochrane, who at the time was executive director and chief investment officer of the $3 billion North Dakota State Investment Board. In reference to Mr. Wein’s comments, Mr. Cochrane wrote that if North Dakota were a Blackstone client, “I would choke on my next fee payment to The Blackstone Group.”  Blackstone was subsequently criticized by a number of other state pension officials who were unhappy with Mr. Wein’s comments.  But Blackstone – a publicly-traded private equity firm whose stock HCM views as a terminal short9 – and Mr. Wein have nothing for which to apologize in this case.  Mr. Wein’s comments were dead on, and public pension officials do themselves little good by ignoring reality. 

If they want further evidence of the folly of forcing states and cities to pay them unaffordable pension benefits, they should revisit what happened to the unions at General Motors and Chrysler.  President Obama will not be around forever to ignore the rule of law and bail them out when their employers are forced into insolvency by their unrealistic demands.  At the same time, many of the same pension funds that are critical of Mr. Wein’s truth-telling continue to pour capital into Blackstone and other private equity funds, which offer them little more than poor risk-adjusted returns and egregiously high fees (or, in (Groucho) Marxist terms, membership in a club in which they should not be seeking membership).  That is the reality about which they should be complaining.

The carried-interest tax lives on

After months of negotiating and Herculean lobbying efforts by private equity chieftains (they have nothing else to do since the private equity industry is mercifully in the dregs these days), the Senate and House Finance Committees reached a compromise on raising the taxes paid by private equity and other partnerships on their investment profits.  While imperfect (arguably venture capital partnerships should retain such a tax incentive, and the compromise delayed implementation and didn’t fully equalize carried interest and ordinary tax rates), the compromise went a long way to eradicating the special treatment that had been undeservedly meted out to unproductive private equity and real estate investments.  Unfortunately, this bill was part of a larger bill dealing with the extension of unemployment benefits to the long-term unemployed and has not yet mustered the requisite number of votes in the Senate to become law.  Forgive us for being cynical, but perhaps the carried interest tax was never intended to be raised.  After all, the arguments in favor of taxing the labor of private equity and other speculative investments partnerships at the same rate as the labor of teachers, policeman and fireman are irrefutable.  It would be a simple enough matter to separate out this part of the bill from the issue of unemployment benefits and pass it separately, but the Senate does not want to do that.  Accordingly, this tax injustice remains on the books.  One can only hope that it will be corrected.  Need we mention that the Obama administration has been largely silent on this issue while complaining about the failure to extend unemployment benefits and threatening to raise the taxes of virtually every other American of means still alive (as well as those who die after the end of the year)?  Might this have something to do with his donor base, which consists of many private equity executives?
Iran, Israel and moral deficits

Moral certitude tends to make people uncomfortable.  We live in an age when we are taught to be nonjudgmental.  But it is abundantly clear that this nonjudgmental approach isn’t working.  The quality of life is not improving.  Problems are not being solved despite the advances we are making in science and technology.  We can decipher the human genome, but we are incapable of discerning the human heart.  There are more people going hungry than ever before, and more people threatened with extinction by human action than ever before in the history of man.  Now is not the time for moral equivocation – it is the time for bold and forthright action to prevent the threats staring us in the face from materializing and wreaking havoc.  Lord knows there are enough hidden threats that we will have to deal with when they are unleashed.

Nowhere does the Obama administration appear to be more out of its depth than in dealing with the growing nuclear threat of Iran.  CIA director Leon Panetta made some statements on ABC’s Sunday show “This Week” on June 27 that should alarm every member of the community of civilized nations (which does not include Iran).  What Mr. Panetta told ABC discredited for once and for all the fairy tale that Iran stopped work on nuclear weapons in 2003.  “We think they have enough low-enriched uranium right now for two weapons.  They do have to enrich it, fully, in order to get there,” said the CIA chief.  “And we would estimate that if they made that decision, it would probably take a year to get there, probably another year to develop the kind of weapon delivery system in order to make that viable.”  With respect to sanctions, Mr. Panetta did not mince words either.  “I think the sanctions will have some impact…It could help weaken the regime.  It could create some serious economic problems.  Will it deter them from their ambitions with regards to nuclear capability?  Probably not.”  In other words, the head of America’s spy agency is publicly saying that sanctions won’t work.  Yet this is the policy still be pursued by the Obama administration as Iran moves inexorably towards possession of weapons of mass destruction that directly threaten Israel, Europe and other interests of vital importance to the United States.  It is difficult to determine which is more disturbing - the seeming naiveté of the administration that sanctions will actually deter Iran from its nuclear ambitions, or the lack of urgency in dealing with the problem.

It is in this context that the president’s lackadaisical reaction to the demise of White House correspondent Helen Thomas was particularly disappointing.  While his press secretary Robert Gibbs properly deemed “reprehensible” Thomas’s statement that the Middle East conflict could be solved by sending Israel’s Jews back to Poland and Germany, Mr. Obama could only cough up a weak rebuke that her comments were “out of line” and “offensive” before saying that Thomas’s resignation/dismissal was “a shame, because Helen was…really a institution in Washington.”  The very fact that Thomas was an institution when her abhorrent views were widely known is a stain on the press and the White House.  Would Mr. Obama have reacted with such equanimity had Thomas suggested that the Palestinians be returned to their true homelands in the other Arab States?   I think not.  Mr. Obama likes to speak about teaching moments, and Thomas’s hateful comments were no doubt one such moment.  But instead of using her hateful statements to instruct the American people on the difference between right and wrong, Mr. Obama hedged his bets and softened what should have been withering criticism of an individual long known for her anti-Semitic views.  Such a reaction is, unfortunately, completely consistent with Mr. Obama’s treatment of Israel and the entire Middle East quagmire.  He needs to understand that he is no longer a State Senator from Illinois but the President of the United States, and his actions and policies are placing the entire world at risk. Americans have every right to be profoundly disappointed in his leadership in what may be the most important area of his stewardship of this nation.

Fortunately, Israel has no such illusions about the existential threat posed by Iran and cannot afford the luxury of trying to win any global popularity contests.  The Jewish state is therefore taking steps to deal with the problem before it is too late.  The latest media revelations – which have been known to the Israeli and U.S. governments for several months - that Iran has armed Syria with a sophisticated radar system that could threaten Israel’s ability to launch a preemptive strike against Iran’s nuclear facilities moves closer the day when Israel will have no choice but to act unilaterally and preemptively.  This radar system reportedly could increase the accuracy of Hezbollah’s missiles and bolster the terrorist group’s air defenses on Israel’s northern border, and there is other evidence that Hezbollah has rearmed itself with far more effective weapons than it possessed the last time it went to war with the Jewish state.  People should understand that a war in the Middle East is likely to be a drawn-out affair; this is no longer 1967, and the dominance of Israel’s military can reasonably be questioned in view of its recent performance and changes in Israel society.  Americans in particular should harbor no illusions that Israel will be able to simply walk over the Arab states if it is forced into making a first strike against Iran.  Instead, an extended conflagration, with all of the attendant consequences (intended and unintended) should be anticipated.  To put it mildly, such a scenario will make the current flight from risk look like a stroll in the park.

The quotation from Shelby Steele that opens this newsletter was drawn from an essay defending Israel’s right to defend itself from so-called humanitarian shipments into Gaza, which Martin Peretz has properly described as “jihadist ship[s] dressed up as Mississippi River cruise boats.”10  Without disputing the fact that Israel should have found a better way to handle that matter (the Palestinians and their supporters set a trap and the Israelis foolishly fell right into it), Israel’s fate is tied to the fate of the Western world as both face existential threats to their democratic way of life.  The Obama administration is not simply failing to protect the interests of the United States with its misguided and weak Iran policy; it is threatening the future of Western civilization.  One would think that all of the alleged geniuses in the administration – we keep hearing how incredibly smart these people are – would have learned some of the lessons of history, including the lessons of appeasing tyrants.  For all of his faults – and they were many – George W. Bush understood that lesson very well.

Michael E. Lewitt

8 The King Report, June 4, 2010, p. 2.

9BX has traded back below $10/share recently.  We believe BX is worthless if the company accurately valued its private equity holdings.  Speaking of which, we got a huge kick out of the June 28, 2010 story in the Financial Times reporting that TPG and Blackstone were carrying their joint investment in the Freescale Semiconductor buyout at dramatically different valuations.  Blackstone is carrying (and reporting to its investors) its Freescale holding at 45 cents on the dollar while TPG is carrying it at 20 cents on the dollar.  Each firm contributed approximately $1 billion in equity to the overleveraged $16.6 billion deal in 2006.  This means that Blackstone is valuing the same investment at $250 million more than TPG.  Something is rotten in the Kingdom of Denmark.  The reality, by the way, is that both firms’ stakes are currently worthless.

10 Martin Peretz, The New Republic, “Homeward Bound: Notes on Helen Thomas,” July 8, 2010, p. 8.