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Blago and Bernie

December 15, 2008


Good morning. We actually had an inside week for the market last week, with the SPY down only about a point on the week. The VIX (volatility calculation for the S&P 500) was also down around four points on the week, still closing at a very historically elevated 54.28. Some of you probably noticed that we were able to put some money to work last week for those using put spreads for protection, as there were a couple “windows” of opportunity to commit a modest amount of funds. We were able to sell, and cover very quickly for a profit, some calls in the PIP. There also was some opportunity for some of the more aggressive (covered straddle writes) positions discussed last week, and they have worked out well so far.

Thank you to all those who attended the seminar last Saturday. As usual it was a terrific group looking to learn about alternative ways of investing in a very tough investment climate. Clearly the message is that there is no real easy one-answer solution that fits all investors right now, but there are a variety of limited risk strategies that either alone or in combination can be appropriate and effective right now. The performance of the Protected Index Program continues to be very solid, but current prices are forcing customization for a lot of the new clients. That is OK, however, we have the people and knowledge necessary to make sure (with your help) that we find the strategies right for you. Those unable to attend the seminar should watch our website for news of the next online seminar.

The main news last week came from two surprise news stories, the first being the arrest of Illinois Governor Rod Blagojevich, and the second being the arrest of financier and hedge fund manager Bernie Madoff. Other than being something for the 24-hour news people to pontificate on, why should or does either of these events affect you or me and our investment strategies? I guess the general answer would be two further examples of the extensive fraud on all levels that, in many ways, is really at the core of our current economic and possibly soon-to-be social crisis.

It would be impossible for anyone in Illinois to have avoided the onslaught of news regarding the Governor this week. He was arrested amidst an amazing amount of audiotape laced with profanity showing that he had essentially put the Senate appointment to replace President –elect Obama up for sale. Of course the investigation goes way deeper and also involves real estate commission to the Gov’s wife in return for large state (mostly no-bid) contracts, large campaign contributions to “Friends of Blago”, etc. The papers and talking heads have been falling all over themselves to point out the corruption in the system, opining on whether now, finally, with this arrest, the Fed’s have gotten to the bottom of the problem, blah, blah. All interesting as stuff on TV, but why should you really care and how might it affect your investments?

I think we need to care because of the economic reasons behind the fraud, not just in this case but on virtually every level of government in this country. We need to understand the underlying reasons for fraud to really stop it, and for some reason I have not heard or read anyone looking at the causes. Why do we need to stop it? Is it too late to stop it? I think we need to stop it because the economy (and the market) cannot stand a situation where multiple states and hundreds of municipalities declare bankruptcy and renege on their obligations. Fraud is an economic problem (opportunity) that presents itself within a flawed system, and the system is seriously flawed. What I mean is that the State of Illinois (and other states, and the City, the County, and the Fed) pay way too much for their services, meaning that there is room for graft. There is no room for graft if things are correctly priced, meaning competitively bid. It would not make people more honest, just unwilling or unable to pay.

What do I mean? I will give a simple example. PTI is in the money management business; we have a solid track record that in this market most manager’s can only dream about. You would think that there would be a mechanism where we could make application (I mean with a chance to be heard) to, say, the Illinois Teacher Pension Fund. We have explored this possibility. In order to get in front of this “august” pension body the cost has been rumored to be some combination of the whole first year’s fee to someone who can actually deliver the funds, a flat fee to some gatekeeper hack just to get in front of the Board to make a presentation, or serious entertaining to the “consultant” hired to “manage” all the supplicants to the Board. Where is the real problem? The economic problem is that the State pays (from what I can determine) at least 1% annually to managers plus ridiculous consulting fees to several layers of consultants. They are paying too much. I would do it for half of that. My point is that if the process was competitive the number paid (for a state on the verge of bankruptcy) would be closer to .5%, not in excess of 1%. That leaves a lot of money paid in excess of a competitive rate “available” for fraud. I would not pay graft on principal, but if someone paid me twice what I was willing to work for there would be funds “available” for that purpose. Anyone would at least think seriously about paying.

What I am getting to here is that every time you see someone hauled away for graft on a road project, graft on a Katrina trailer, graft on an Army mess contract in Iraq, immediately think that whoever let that contract overpaid, probably for a self-serving reason. If they paid the right price, there would be little or no graft, not for reasons of honesty but because there is none to give. Every time this overpayment happens, you, the citizen, are the one overpaying. The problem is that now it has reached the point where it is so widespread at every level of government, and a lot of these governmental bodies are so broke or over leveraged for these and other reasons that failure is a possibility. Is that a potential problem for an investor? I would say absolutely yes.

What about Bernie Madoff? In a lot of ways it is still unfolding. I was familiar with the Madoffs during my years on the CBOE Board. They were one of the early stock “preferencing” firms that really cause a lot of changes to the investment world. In those days the minimum “tick” for a stock on the NYSE was an eighth of a dollar, and that was a NYSE rule. Similar to my previous discussion on graft, the economic fact was that an eighth was too much. Bernie used the Cincinnati Stock Exchange as a platform to lure stock trades where he would “honor” the NYSE market (meaning give you, the investor, the fill at the listed NYSE price) on the Cincy. In return for “directing” this trade to the Cincy he would “rebate” the firm at least a penny a share. Sounds innocent, you would get the same fill you would get on the New York, who was hurt? The answer is, you were hurt. You were charged as if your trade was done on the NYSE, you could not now benefit from the fact that a large percentage of trades done on the NYSE were done “between” the markets, and for a long time you were never told of the sleight of hand. Only after years of complaints did our virtually useless SEC require you to be even told that this was happening. They never did stop it on moral grounds. Eventually they “solved” the problem by narrowing the minimum tick width, which effectively removed the “source” of the excess money available for the “graft”. Anyway, that is how I remember Bernie. I never really knew about the extent of the hedge fund issues beyond that one thing he did, or the following he developed among people that should have known better.

At PTI most people ask, or research on their own, who we are, how long we have been around, who Mesirow is, what about SIPC, how can the access their account, how quickly trades are posted for them to see, etc. How can there be a whole set of otherwise intelligent people (law professors, university presidents, charity Boards, etc.) that invested their own and other people’s money in a place with no statements, no transparency, etc. How many other hedge funds that are restricting withdrawals could be in the same situation? To be determined.

What’s on tap for this week? We will continue to put some funds to work if the opportunity is there. We also will continue to contact those people who may have some obvious tax issues. Again, I cannot emphasize enough the necessity of involving your tax advisor early this year. Find out, if you can, whether you have any possibility of rolling gains back to previous years, whether you have losses other places, etc. We will continue to be aggressive in the Protected Index Program in trying to take advantage of the continued high volatility levels. Let’s make it a good week.