Click on the pic to view the video on the original site.

H/t Rational Walk.

H/t The Big Picture.

If you have any doubt about the need for reforming the credit rating agencies, and The Great Recession wasn’t evidence enough, I’d highly recommend Michael Lewis’ The Big Short
for some perspective. And after all we just went through, it’s hard to imagine anyone in charge of managing others’ wealth expressing any kind of support for perpetuating the current system.

But then there are the mutual funds. From an article in today’s WSJ (emphasis mine):

Making this tale even stranger than fiction, S&P has said it is ready to give up its special status. The political problem now is that the mutual fund industry is lobbying to maintain the cartel. Both regulators and fund managers have figured out that doing their own analysis to decide what constitutes an “investment-grade” bond is hard work. But if some third party (such as Moody’s) has deemed a bond safe, no one can second-guess the mutual fund for owning it.

To put a finer point on it, the raters give mutual funds a shield from lawsuits if their investments go sour. All the more so because the Senate and House reform bills contain provisions that will make it much easier for plaintiffs attorneys to sue the credit raters. As long as the cartel remains, everyone is covered—except the individual investor, who loses money when the cartel members rate the next Enron as highly as they rated the last one.

The irony is that it’s the individual investors in those funds who are helping to pay for the same lobbying efforts that end up screwing them over.

Sigh. Long live spoke funds.

The trading departments of Bank of America, Goldman Sachs, JPMorgan Chase and Citigroup each finished the first quarter of this year having made money every single day. According to their SEC filings, their traders did not lose a single penny on a single day the whole quarter. For 61 days in a row. All four of them. Really.

Now I haven’t determined the actual probability of that occurring in a truly free market, but I’m going to guess that it’s indistinguishable from 0.0000. That is, there is zero chance these guys are really that good. (See TARP, 2008.)

But when you’re acting like some kind of emerging market oligopoly, screwing over your own clients and letting computers trade for you, apparently it is just that easy. And as I’ve said before, investors beware. These big banks are lousy businesses. They have no sustainable moats. After all, it wasn’t one bank but four of them that just threw perfect games.

There’s more in this article from the NY Times – although it inexplicably fails to raise the question, “How exactly did this occur?”

This gentleman’s quote pretty much summed it up:

“This is just, as we call it, milking the market and your captive client base.”

Exactly, dear sir. This has nothing to do with talent or being a steward of wealth.

Unbelievable, isn’t it?

In one of the greatest investment markets in the world, namely, New York, the influence of speculation…is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare, one is told, for an American to invest, as many Englishmen still do, “for income”; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator.

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism — which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.

1. “I would make Paul Volcker look like a sissy.” Charlie on financial reform.

2. “If you give people unlimited credit, they will go plumb crazy. And they did.” Charlie on reform again.

3. “It would be both unfair and stupid. I don’t think the government would be that crazy.” Charlie on reform that would require posting collateral on existing derivative contracts.

4. “I don’t know how this movie ends. And generally I don’t go to movies like that.” Warren on the debt crisis in Greece and whether he is looking for opportunities in Europe.

5. “There are plenty of CEOs I’d like to see gone in America, but Lloyd Blankfein is not one of them.” Charlie on the head of Goldman Sachs.

6. “I knew enough to lend them money but not enough to buy the equity.” Warren on buying debt, not shares, in Harley Davidson during the financial crisis.

7. “We celebrate wealth only when it is fairly won.” Charlie on excessive compensation.

8. “We are deliberately seeking big losses in a single year. We want to be so rich that the loss is just a blip long-term.” Charlie on Berkshire’s reinsurance business.

9. “Trend is not destiny.” Warren.

10. “The politicians are not behaving better as the newspapers are getting weaker.” Charlie on one of the side effects of a declining newspaper industry.

11. “I developed more courage once I learned I could handle hardship. Maybe you should get your feet wet in failure.” Charlie to an investor nervous about the economic outlook.

12. “That is a stunningly stupid idea.” Charlie on the economics of ethanol.

“SEC staffers watched porn as economy crashed.“

Okay, so it’s two sentences. More here, from the battle on financial reform taking place on the Hill. And here’s a paper I wrote a few years ago about the problem of credit default swaps.

It’s probably fair to say that the amount of lobbying dollars spent by the Wall Street banks in DC is directly correlated to the size of their profit margins under threat. So this is going to be one heckua fight. But let’s be clear – the debate over derivatives you’ll be hearing about in the weeks ahead has nothing to do with economic freedom, limiting customers’ flexibility, or any other rhetoric. Banks don’t want any transparency into derivatives because the margins are so large. Sunlight means less profit – full stop. And while there’s no bigger fan of profit than me, if it comes at the expense of pulling the wool over your customers’ eyes, then it’s fair to question how sustainable those profits really are.

Politics aside, I think the huge pushback the Wall Street banks are mounting to what really should be a no-brainer part of reform underscores one key insight for investors: these banks don’t have sustainable moats.

Whatever economies of scale they might have are dwarfed by the complexity of their businesses, and that scale is certainly not evident in their internal returns. While there are plenty of sharp folks who work for the big banks, from a business owner’s perspective, that’s kind of like seeing your competitive advantage walk out the door every night.

So a point that I think gets lost in all the rhetoric these days is that these banks are lousy businesses. I would have thought that obvious to anyone alive in 2008, yet somehow it is not. Wall Street banks don’t represent the best of American companies, nor do they have any interest in truly free markets. I suppose you might respect their power and their unique political connections, but they shouldn’t get any credit at all for building enduring businesses. And shouldn’t that be at least a little relevant here?

When it comes to financial reform, Wall Street banks certainly don’t deserve a seat at the negotiating table because they’ve earned it. They bought it. Here’s to hoping we see that change.

Update: Um, never mind. This is now the most amazing sentence I’ve read this week:

“U.S. Accuses Goldman Sachs of Fraud.”

Sounds similar to the Magnetar trade.

And from a political strategy perspective, this announcement is arguably brilliant in terms of timing. Not only has Goldman’s seat at the reform table imploded, but the other big banks just saw the height of their chairs drop by about a foot.

Well-played, Forces of Good. Now, break up the banks, and I’ll quit badmouthing you for at least a week.

“In August 2008 my oldest daughter was 18 and in her first year of college. I sat down and drafted a one page list of what I thought at the time were timeless pearls of money wisdom and gave her the list. It was based on 20 plus years of personal experience and education regarding money management. Anyhow, I came across it last night and after reading it, I still think it represents timeless personal financial planning wisdom. I thought of you and I’ve attached a copy for you. I’m sure it’s pretty basic stuff for someone who manages money for a living but I thought you might like to see what type of advice some parents give to their teens.”

Here was Neal’s list:

-Save first, spend later: have emergency savings, retirement savings, and investment savings plans.

-Pay yourself first, live on what’s left: use automatic investments direct from pay or checking account.

-Live within your means: don’t try to compete with others.

-Be frugal, but not stingy: avoid wasting money.

-Diversify between and within investment classes.

-To excel at something, immerse yourself: educate yourself on whatever you invest in.

-Swear off debt: borrowing money is like wetting the bed, it may feel warm at first but the cold reality hits in soon.

-Do what you love: find work in something you love and it’s more like a hobby than work; there are few things worse than getting up everyday and going to a job you don’t enjoy just because you need the money.

-Know where your money goes: track income and expenses closely and analyze the results periodically.

-Equities build wealth: it’s the best way to build wealth over time.

-Money can’t buy happiness.

-Don’t get too good at the wrong stuff: be good at something that will get you noticed and that has a future for either growth or advancement.

-You can’t reliably beat the market; use index funds and take the average.

-Take risks where you can within your personal risk tolerance: greater risk normally means greater returns, but not always.

-If you can’t afford to lose your investment, don’t invest, save.

-Tap the power of compounding: start saving early.

-Carry small amounts of pocket cash and use small bills to avoid feeling wealthy which may deter needless impulse buying.

-One credit card maximum: for emergencies only and then pay off the balance each and every month.

-You can’t fight the market so join it; use index funds.

-Buy low, sell high: have a target buy price and sell price with reasons for both, and stick to it.

-Don’t follow the herd: if it makes sense for you, do it even if it runs counter to the crowd.

-You don’t know more than the market knows: use index funds.

-The less you pay, the more you keep: look for low costs or fees and/or tax free or deferred investments.

-Always get it in writing.

-Leave your money alone: rebalance your investment portfolio once a year.

-Invest for the long term: stay the course.

-Be humble about what you don’t know: don’t be afraid to ask questions.

-Develop a healthy skepticism: if it sounds too good to be true, it probably is.

-Be careful of the people you trust since by definition they are the only ones that get the chance to screw you.

-Ignore short term market swings: avoid trying to time the market, you can’t.

-Nobody plans to fail, but many people fail to plan: make one and stick to it.

-Real estate has been the secret to getting rich for centuries.

-Avoid speculation: don’t buy anything you don’t want or sell anything you don’t have.

-You can’t get something for nothing.

-Character, not assets, counts the most in the end: don’t lie, cheat or steal.

I think it’s great. What do you think?

2. Yet another reason to kill your television. “In the U.S., we spend 100 million hours every weekend, just watching the ads.”

3. Wall Street’s Bailout Hustle. Equal parts entertaining and disturbing.

4. Government’s proper role in the market. Surprisingly coherent argument from that politician who disgraced himself a while back. Too vague?

5. A Roadmap for America’s Future. Another rational idea from a politician. What in the world is going on here???

6. Story on hedge fund manager Mike Burry, from a new Michael Lewis book that one reviewer called, “Probably the single best piece of financial journalism ever written.”

7. This could only happen in the Keys. Best tip from the police: “Don’t try to shave your privates, either.”

Video of the speech will be posted once edited.

And a special thanks to the gracious Gil Bento for setting it all up!

The Hidden Costs of Mutual Funds

Portfolio managers can rack up steep expenses buying and selling securities, but that burden isn’t reflected in a fund’s standard expense ratio.

How much does it cost you to own a mutual fund? Probably a lot more than you think.

In selecting mutual funds, most investors know to check the expense ratio, the standard measure of how costly a fund is to own. U.S.-stock funds pay an average of 1.31% of assets each year to the portfolio manager and for other operating expenses, according to Morningstar Inc.

But that’s not the real bottom line. There are other costs, not reported in the expense ratio, related to the buying and selling of securities in the portfolio, and those expenses can make a fund two or three times as costly as advertised.

“These trading and transaction costs are very real,” says Stephen Horan, head of professional education content and private wealth at CFA Institute, a nonprofit association of investment professionals. “While it’s very important to look at that expense ratio, it’s just not going to capture” all of the costs, Mr. Horan says.

Read the entire article here. Morningstar’s estimates of the average fund expense ratio in the above is lower than the industry’s own estimates. I compare mutual fund costs to spoke fund costs here. And sign up here to receive my article “Ten Things You Must Know Before Investing in Mutual Funds.”

On successful investing:

We’ve put a lot of money to work during the chaos of the last two years. It’s been an ideal period for investors: A climate of fear is their best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance. In the end, what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two.

On the bailouts of last year:

In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees – the financial consequences for him and his board should be severe.

It has not been shareholders who have botched the operations of some of our country’s largest financial institutions. Yet they have borne the burden, with 90% or more of the value of their holdings wiped out in most cases of failure. Collectively, they have lost more than $500 billion in just the four largest financial fiascos of the last two years. To say these owners have been “bailed-out” is to make a mockery of the term.

The CEOs and directors of the failed companies, however, have largely gone unscathed. Their fortunes may have been diminished by the disasters they oversaw, but they still live in grand style. It is the behavior of these CEOs and directors that needs to be changed: If their institutions and the country are harmed by their recklessness, they should pay a heavy price – one not reimbursable by the companies they’ve damaged nor by insurance. CEOs and, in many cases, directors have long benefitted from oversized financial carrots; some meaningful sticks now need to be part of their employment picture as well.

And, in case you’re wondering – yes, although it looks a bit odd, apparently it is acceptable to spell “benefitted” in the above with two t’s. But I had to Google that to be sure.

Uh, did I mention I get a bit obsessed with these letters?

Anyway, the best quote attributed to Charlie Munger:

Are we supposed to applaud because the dog that fouls our lawn is a Chihuahua rather than a Saint Bernard?

And the closing thought:

At 86 and 79, Charlie and I remain lucky beyond our dreams. We were born in America; had terrific parents who saw that we got good educations; have enjoyed wonderful families and great health; and came equipped with a “business” gene that allows us to prosper in a manner hugely disproportionate to that experienced by many people who contribute as much or more to our society’s well-being. Moreover, we have long had jobs that we love, in which we are helped in countless ways by talented and cheerful associates. Indeed, over the years, our work has become ever more fascinating; no wonder we tap-dance to work. If pushed, we would gladly pay substantial sums to have our jobs (but don’t tell the Comp Committee).

Here’s the letter in its entirety.

And if you’re thinking about going to Omaha for the annual meeting on May 1st, please let me know!

And here’s a chart from Visual Economics that might lead you to a similar conclusion as the clip above…a little less theatrically. Click on the below for the larger version.

Stay thrifty, people.

“[The business of investing] should be about giving honest-to-god, down-to-earth human beings the chance to accomplish their own financial goals.”

Losing Mutual Funds Still Enjoy Big Paydays.
Despite 2008 decline, some fund giants garnered more than $300 million in fees

Many mutual-fund investors suffered heavy losses in 2008, but managers of some of the largest stock funds – including ones that fell roughly 40% in 2008 – gathered hundreds of millions of dollars in fees during that time.

And later on:

[Morningstar analyst] Dolan also suggested that the dollar amount brought in by fees be expressed in terms of total returns delivered by a fund. For example, if a fund’s returns in a year amounted to about $600 million, and it realized $300 million in management fees, investors would have a clear picture of how much fees affected returns.

The entire article is here.

It is the nature of markets that sometimes events as distant as the surprise election of a Republican senator in a formerly deep blue state can have huge and previously unforeseen ramifications. I, like many others, did not see Scott Brown’s last Tuesday victory coming a month ago, nor had I really considered its impact on the markets beyond the myopic and obvious “that oughta be good for healthcare companies” kind of thought. But by Thursday, President Obama’s speech on the Volcker Rule made it fairly clear: some huge new variables just stormed through the door for investors.

In case you missed it, the administration intends to prohibit banks from running hedge funds, private equity funds and participating in the very profitable practice of proprietary trading, and, well, that’s a big deal – in both action and intent, as the market’s subsequent sell-off underscored.

Here is the announcement:

To be clear, there is still a high degree of uncertainty about how this proposal will play out. Congress will no doubt take its time to enact these changes, during which time bank lobbyists in DC will multiply like rabbits.

And far as what these variables mean to our portfolio companies, the answer at least in the short-term is “nothing.” I am already hyper-allergic to regulatory risk in our holdings, which is one reason we don’t own shares in any banks or health insurance companies.

But without being too dramatic, I think there is a reasonable probability that we may have just seen the formal beginning of a generational shift in this country’s attitudes about capitalism. Or, at least, that is where all this could be going if the early political tea leaves prove correct.

Here’s the best article I’ve read describing the political calculus that is likely involved behind the scenes. It’s from Simon Johnson at MIT, who has been out front in many ways on his Baseline Scenario blog. Here’s his assessment of the current political calculus going on in the White House:

Think of it this way. If the Democrats lose badly in November – as seems likely, with their current weak and unconvincing narrative about the financial crisis and origins of our mass unemployment – then President Obama’s reelection campaign will be a long struggle to redefine the message, presumably toward finding something he has changed in a major way. In that context, strong attempted action against the power of big banks would appeal to the left, center, and even part of the right. Why wait for defeat in November before making this switch?

Run hard now, against the big banks. If they oppose the administration, this will make their power more blatant – and just strengthen the case for breaking them up. And if the biggest banks stay quiet, so much the better – go for even more sensible reform to constrain reckless risk-taking in the financial sector.

The difference, then, between this week’s Volker Rule announcement and the previous year’s half-hearted attempts to reform the Street is that this time they mean it. Financial reform is now at the center of a fight which will be politically convenient, entirely one-sided and easily satiate the masses. If this recent change in strategy is in fact successful in solving the President’s current political problems, then it may redefine both politics and Wall Street for at least the next seven years.

We can get a glimpse of other potential White House financial reform proposals thanks to the hyperkinetic Tyler Durden(s) over at Zero Hedge. Tyler dug up the below report, published a year ago by the “Group of 30,” a little-known DC think-tank led by Timothy Geithner, Larry Summers and, yes, Paul Volcker. It touches on reforming everything from rating agencies to accounting to Fannie Mae, and it could very well prove to be a blueprint for regulatory change over the next few years.

If you are an investor, you owe it to yourself to at least skim the below in an attempt to gauge how much these changes could impact your own portfolio. Like, later today. Seriously. If nothing else, just watching five minutes less of Terry Bradshaw will make you smarter. If you have questions about anything in here, ask your advisor about them. If he can’t answer them, fire him. Regulatory risk just became the biggest potential headwind in your portfolio over the next fourteen conference championship games, and after last Thursday, the “didn’t see it coming” excuse shouldn’t cut it.

Though I try hard not to be cynical about politics, I concede I am a bit disappointed that these proposed changes seem to have been driven by political justifications, not moral ones. The collapse of Bear Stearns happened almost two years ago, yet it was only an off-the-radar Senate race two days ago that gave the political handicappers the odds they wanted to come out in favor of aggressive reform – or at least of appearing in favor of it.

And as much as I bash Wall Street – and unequivocally agree that changes are clearly needed – I find myself, surprisingly, lukewarm at best about the Volcker Rule. I suppose my usual skepticism of institutional motivations may have just gotten trumped by, well, a bigger institution. Or maybe it’s the law of unintended consequences that concerns me. Regardless, if we as a country decide to selectively begin real, critical financial reform to prevent another global financial meltdown, I’m in. If we end up doing this as punishment, though, or because we want retribution from Wall Street, well, then, I’ll be out fishing under Long Key bridge.

I consider myself a strident advocate for more transparency, disclosure, and above all, enforcement in the markets. While this new proposal has some merit, it is only in the context of fixing what we’ve already got. It’s also easy to see this thing end up getting highjacked during the legislative process and becoming a big distraction from one of the dozen other Really Important Things we as a country need to be working on. Like a playoff system for college football.

All that said, I really don’t want to see another crisis like the one we just went through. Ever. So I will hunker down and get onboard with this reform – if the powers that be in DC and Manhattan remember a few things:

The markets exist to serve us. We get into trouble when we start thinking it’s the other way around. Our elected representatives also exist to serve us. They, too, get into trouble when that order is confused.

So no matter what is in store during this upcoming battle, we should all be hoping that both sides remember who it is they’re working for.

Restoring Faith in Financial Markets
It is time institutional investors exerted control over publicly held companies.

‘Investing is an act of faith.” So I wrote in 1999, the very first sentence of my book, “Common Sense on Mutual Funds.” But as 2009 ended, writing in the updated 10th anniversary edition after the passage of this turbulent decade, I concluded that “the faith of investors has been betrayed.”

How so? Because the returns generated by our corporate stewards have often been illusory, created by so-called financial engineering and produced only by the assumption of massive risks. What’s more, too many of our professional money managers have failed to act as vigilant stewards of the money that we investors entrusted to them.

In short, far too many of our corporate and financial agents have failed to honor the interests of their principals—the mutual fund investors and pension beneficiaries to whom they owed a fiduciary duty. The ramifications were widespread—for the failure of money managers to observe the principles of fiduciary duty played a major role in allowing our corporate managers to place their own interests ahead of the interests of their shareholders.

Over the relatively brief span of a half century, our institutional agents have come to be the dominant force in corporate America. Institutional investors held less than 10% of all U.S. stocks in the mid-1950s, 35% in 1975, and 53% a decade ago, and now institutional investors own and control almost 70% of the shares of U.S. corporations. Mutual funds own the predominant amount, 26%; private pension plans another 11% and government pension plans another 9%.

The rise of agency ownership has been steady, and seemingly inexorable. But this revolution in equity ownership—it is no less than that—has been accompanied by many shortcomings, in part because it linked the agents of corporate America with the agents of investment America. As Leo E. Strine, vice chancellor of the Delaware Court, observed in a speech in 2007, “No longer are the equity holders of public corporations diffuse and weak . . . (they) represent a new and powerful form of agency, which presents its own risks to both individual investors and . . . the best interests of our nation.” Yet, he noted, professional money managers are no less likely “to exploit their agency than the managers of corporations that make products and deliver services.”

Read the rest here.

As I mention in the article, it’s hard to imagine a group more tied to the outlook for housing in this country than hardware retailers. What I didn’t mention is that I’d spent a decent amount of time looking at Home Depot shares last spring. Though I ultimately passed, there were still some useful takeaways from the work I did that were also of interest to hardware store owners. That’s one of the things I most like about being an investor…you never know when all that data in your cranial hard drive will come in handy.

And I suppose I should explain how someone with no obvious connection to the hardware industry got published in a nationwide trade journal. My office is a converted dynamite warehouse that shares a back wall with an Ace Hardware store (MM92, B/S), so I tend to wander over there often for renovation tips and, well, to shoot the bull. The store owner is a very savvy local businessman who also publishes the Connection, and after several long discussions about credit default swaps, he offered me the chance to write a column. That’s one of the things I most like about being in the Keys…you’d never guess how far people will go out of their way to help you be successful – until you see it with your own eyes.

In any case, click here to see the online version of the magazine. My article starts on page 47.