In Search of the Perfect Investment

Remember Auction Rate Preferreds? A few years ago, the brokers and the banks peddled them as alternatives to savings accounts. Here’s what they were:

Auction rate securities (ARS) are debt or preferred equity securities that have interest rates that are periodically re-set through auctions, typically every 7, 14, 28, or 35 days. ARS are generally structured as bonds with long-term maturities (20 to 30 years) or preferred shares (issued by closed-end funds).

I was sold a whole bunch by my broker. He said “They’re just like cash. Except you get some interest.” The bankers would turn up, bid on them — setting the interest rate — and we’d go another week or two.

Then one day the bankers didn’t turn up. They were never legally obligated to. And my millions of dollars of auction rate preferreds went from “just like cash” to “just like valueless.” Poof!

I got to thinking: Wall Street is a product machine. It invents products it can peddle — for a commission — to gullible investors (like me) who are always looking for the latest way to make a small fortune. With old age, I’ve lost my gambling instincts. But hedge funds clearly haven’t.

There’s probably no faster way to become a billionaire these days than open a hedge fund, take in other people’s money at 2% and earn 20% of the profits. The more outside money you can attract, the more money you can make for yourself. But, to get in oodles of money you have to do well — better than the indexes and better than the hedge fund next door. “Doing better” means taking more risks.

Last week we saw hedge funds take enormous risks gambling on the VIX. See my previous column here. Another time was on sub-prime mortgages and we all remember where that lead — the bankruptcy of Lehman Bros and an almost systemic financial failure.

This week I started worrying that this mess with VIX, bitcoin, and the lack of financial oversight (The Trump administration is defunding protections like the Consumer Financial Protection Bureau, the Justice Department, etc.) could create another systemic failure and bring markets crashing down. They’re already frothy.

I started to investigate “gambling” instruments — also called derivatives. Anything that derives its value from something else. Warren Buffett has called derivatives “weapons of mass destruction.”

So, I wanted to know how unsafe were our markets. After all, they’ve been straight up since 2009. And, after the blips last week, it’s resumed upwards. Here’s the last ten days.

I started with ETFs. In my gut I saw these things as similar to auction rate preferreds. Now I know everyone and their uncle (including me) owns them. But they’re not stocks. They’re allegedly baskets of stocks managed by various and sundry financial institutions who may or may not turn up that day to ensure that my ETF is worth what it should be.

Among my researches, I found these words on Schwab’s web site:

While it’s true that such ETFs come with specific risks, they might also offer higher returns or exposure to otherwise desirable assets. But it’s worth handling them with care. They can make sense as part of a long-term strategy, but they’re probably not a good choice for short-term investing as it could be hard to sell at a desirable price during a downturn.

Best practices (from Schwab)
ETFs offer diversification at low cost, which helps explain their growing appeal. We don’t think they’re inherently dangerous. (Harry’s bolding.) Nevertheless, it can make sense to follow a few rules of thumb when trading them.

Avoid trying to sell during a market crisis. Extreme volatility tends to be short-lived, and selling during a panic can lead to losses.

Use limit orders. These are orders to buy or sell at a set price (the limit) or better. Specifying the price at which you are willing to buy or sell an ETF does not guarantee execution, but it does protect you from executing a trade at a disagreeable price.

Avoid trading when markets open or just before they close. They tend to be more volatile then.

Think about this: Schwab sells billions of dollar of ETFs. Yet, they write “We don’t think they’re inherently dangerous.” Are they saying they’re just straight out plain dangerous? My brain screams YES.

I’m mulling all this. Then I find a piece from the London School of Economics headed:

Systemic risk was the real culprit in the 2008 financial crisis and, with banks continuing to borrow huge amounts, the dangers are still there.

The article contains these two important paragraphs:

In other words, subprime losses led to a financial crisis in 2008 because the banks were more highly leveraged relative to their capital and also, crucially, more dependent upon short-term funding markets. The 2008 financial crisis was, above all else, a crisis in and of the wholesale funding markets which arose when institutional investors stopped lending to any banks at any price in the knowledge that some of those banks (they did not know which) had incurred losses in the subprime market that would be enough to wipe out their inadequate capital buffers.

Why does this matter? It matters because, five years on from the onset of the crisis, the banks, although more tightly regulated and less leveraged, still require massive amounts of wholesale funding to sustain their balance sheets. In 2006 JP Morgan recorded commercial paper debts of US$18,000m on the liability side of its balance sheet, together with US$133,000m in long-term debt. By 2012 these figures had risen to, respectively, US$55,000m and US$249,000m. Nor is this a one-off story. In 2006 Barclays recorded £177,000m in repurchase agreements and cash collateral on securities lent on the liability side of its balance sheet. By 2012 – after several years of seeking to reengineer its balance sheet away from investment banking – this sum was still £176,000m. Investors in these funding markets are under no obligation to continue lending to these or other banks if and when losses are sustained in housing markets, corporate lending or financial trading. Indeed, institutional investors have good reason not to take any chances when it comes to rolling-over loans to any bank they think might even be close to being nearly in trouble.

Read the full article here. 

I’m continuing to research. For now, I have some rules:

+ No ETFs.

+ No leverage. No borrowing from my brokers — online or in person.

+ No bitcoin. No VIX or VIX funds. No marijuana investments. Nothing hot or fashionable.

+ Absolutely no ETNs. These are clearly WMDs. Here’s how Wikipedia defines these little babies. (Some of the VIX disasters last week were actually ETNs, not ETFs.) Here’s Wikipedia:

An exchange-traded note (ETN) is a senior, unsecured, unsubordinated debt security issued by an underwriting bank. Similar to other debt securities, ETNs have a maturity date and are backed only by the credit of the issuer. ETNs are designed to provide investors access to the returns of various market benchmarks. (Harry’s comment — i.e. gambling.)

On-line banking.

Ally Bank is now paying me 1.45% a year on savings. And 1.50% on a three month CD.

That’s at least one hundred times more than your big bank is paying you on your savings.

1.50% is not a lot. It’s better than a sharp stick in the eye. Or a slap in the belly with a cold fish.

Apple is switching to HIEC 

It’s replacing JPG and PNG as Apple’s preferred way of encoding images. Allegedly, it uses fewer bits. Hence you can cram even more grandkid photos into your iPhone. Of course, there’s no software for a computer that will want to open HIEC files. Hence you need a converter.

It’s called the iMazing HEIC Converter. It works. I tested it. You can pick it up for free here. 

Soon the desert air here will have a new ingredient

Coachella, CA is building a 90,000 square foot indoor factory to grow marijuana. Allegedly Desert Hot Springs will have a million square feet to grow the stuff. A friend is about to feed medical marijuana to her ailing dog.

The California Marijuana Boom may rival its Gold Rush. Except you can’t grow gold. They’ll soon be an oversupply of dope. They’ll be giving the stuff away on street corners.

How pregnant women should exercise

The room was full of pregnant women with their husbands. The instructor said, “Ladies, remember that exercise is good for you. Walking is especially beneficial. It strengthens the pelvic muscles and will make delivery that much easier. Just pace yourself, make plenty of stops and try to stay on a soft surface like grass.”

Gentlemen, remember — you’re in this together. It wouldn’t hurt you to go walking with her. In fact, that shared experience would be good for you both.”

The room suddenly became very quiet as the men absorbed this information. After a few moments a man, name unknown, at the back of the room, slowly raised his hand.

“Yes?” said the Instructor.

“I was just wondering if it would be all right if she carries a golf bag?

Speaking of golf. Try this shot.

Harry Newton, who is watching the over-supply of golf courses in the Coachella Valley. The price of membership in golf clubs has dropped by 50% and more. I know of one golf club that went belly up. And no millennial worth his salt plays golf. (That’s an exaggeration to make a point.)

Have you been into Staples recently? It’s horrible. Dreary layout. Depressing lighting. No inventory. No excitement and prices much higher than Amazon’s. Sadly, Staples is private and I can’t short it. But, boy, is the world of retail changing.

I ultimately got all my Auction Rate Preferreds money back. But it took a lot of sturm and drang. I don’t want to go through that with my ETFs.

Sorry about being out for a few days. Thinking about gloom and doom is exhausting.

Just remember: “Wall Street” (that’s broadly speaking) is out to sell you something for today’s commission. They have absolutely no interest in your investment’s success long-term. Again an exaggeration — but worth keeping in the front of your mind the next time you hear “cancer cures” or “three times leverage” spoken with bated breadth.

I’ll be back tomorrow. Promise.