We have met the enemy and he is us.

Good morning, and hopefully everyone had a happy and restful Thanksgiving holiday. The market was mostly positive last week until Friday, the normally sleepy half day after Thanksgiving, when the market reacted to worldwide sell-offs on Thursday due to the impending suspension of interest payments from Dubai World. The SPY was down on Friday from 111.38 to 109.38, or 1.6%, essentially erasing the entire gain of the previous four days, but not nearly as much as the 2-5% drops in other markets around the world. The VIX had a huge jump last week of 11%, from 22.19 to 24.73. Those paying attention to the financial press on Friday were treated to streams of “experts” telling everyone willing to listen that the problems with Dubai World were being over stated and how others would jump in and cover the debt problems for a variety of reasons. Were these the same people that told everyone to not worry about real estate problems here or those nasty collateralized debt obligations?

Anyway, the truth this morning seems to be (according to Bloomberg) that there is no implicit support between Dubai World and the Dubai government, even though it appears that Dubai World had represented themselves in some ways (and in some loan documents) as a quasi-governmental entity. The question then becomes whether the government of Dubai or some other group in the Emirates will come to some aid, and whether new terms can be negotiated with the various lenders. One would probably think that some group in the Emirates will help out at some point (if possible) but, in my opinion, it is probably too soon to label the problems as “just another buying opportunity”. It actually may be time to look at the condition of the debt in other developing countries, including China.

Since I last wrote we have surely had a lot of news relating to Health Care Bills and other legislation regarding new stimulus for the still depressed economy. Associated with that are the shrill cries against any sort of governmental health care “interference” and any further economic stimulus in light of the horrendous Federal balance sheet. There are real people, with real education, on the opposite sides of this debate. Some Economists, notably James Galbraith from the U. of Texas, state very strongly that the only danger is in not enough stimuli, and that Congress should act boldly to stimulate really without any regard for the debt build up in the process. Others, obviously, feel just the opposite, that to constantly throw borrowed money at the economy can be both wasteful and have very ominous long-term consequences. Virtually no one, except those on the dole (meaning those in political office or various governmental employees) have any confidence in governments (at any level) ability to do virtually anything in an efficient manner. I, for one, have a serious issue with giving a couple either $8,000 (for first time buyer) or $6,500 (trading up buyer) that can make $225,000 as a couple and are buying an $800,000 house. I was also really happy with giving a well-off family $3,500 for the 16 year old’s junky train car so the old man could drop his butt in some new wheels.

Why is this bothering me, and, I assume, others? It bothers me because I am sensing that at a time of unprecedented expansion of governmental give away programs there is virtually no attempt being made to deal with the mounting fraud in those programs. Coupled with that I happened upon a release from Peter Orszag, director of the White House Office of Management and Budget, that admits to $98 B in improper payments in fiscal 2009, up from $72 B in 2008. By improper payments they mean outright fraud and misdirected payments due to things like illegible doctor’s signatures. I assume that this number does not include the fraud in any of the military outside contractor programs, or the almost laughable waste in both the Homeland Security or FEMA initiatives following 9/11 or the Hurricane episodes. I shudder to think how much waste there must be with these so-called “shovel ready” pork programs that are the sorry backbone of the current stimulus package.

“We have met the enemy and he is us.” For those who are not up on comic strip quotes, that is the famous quote of Pogo on Earth day, 1971, in the famous comics strip by Walter Kelly, and is an obvious take off on the message sent in 1913 from U.S. Navy Commodore Oliver Perry after the Battle of Lake Erie “we have met the enemy and they are ours.” Who is committing all this fraud? When I rail on the ridiculous fraud in the Homeland Security, Katrina, military contract, etc. programs the name George Bush inevitably surfaces. Likewise, when anyone talks about the potential health care fraud, or the pork in the current stimulus package, the name Barrack Obama come up. I have news for you; however, neither Bush nor Obama is currently or did steal any of that money. It is citizens of this country (or maybe foreigners in some of the military stuff), probably people that we know, doing some of this stealing. According to the Orszag report, $24 B of Medicare out of $308 (8%), $18 B or $188 B in Medicaid (10%), $12 B out of $119 in unemployment insurance (10%), and $12 B out of $48 in the Earned Income Credit Program (25%) is fraud. Add that to the absurd reports of those collecting the $8,000 in the first time buyer program that were not really first time buyers, etc. The collective “WE” are stealing this money, and there does not seem to be any way to stop it. You can imagine the logic “Hey, the Chairman or Bank X got $100 M for running the place into the ground and we had to bail them for $50 B, why shouldn’t I get the $8,000 for buying a house after only 1 year, I will put it in my wife’s name?” Or, “Of course I cashed the check for the more expensive medical procedure, have you ever tried to give money back to the government?” I am also pretty sure that George Bush or the lightweight running FEMA did not order or pay for trailers with formaldehyde in them, yet that is what seems to have been delivered.

Are we frozen with regard to future governmental initiatives, including health care reform, because or endemic fraud and inability to address the problem? I think we might be. Have we reached the stage where every one of us needs to commit a “little” fraud just to stay even? I think you could possibly make that argument. Do we need to import a few Chinese leaders for a little while that might behead a thousand or so fraudulent neighbors to deliver a message? Most would think that is probably a little too harsh. Should we have absolutely no consequences for almost all the fraudulent acts like now? When was the last time a doctor was called out for cashing two checks for the same procedure, or someone was fined severely for not reporting some cash income that would have put them over the amount needed for the Earned Income Tax Credit or qualify for unemployment insurance. What about Wall Street? Virtually never, maybe we should rethink the Chinese method for a little while. I will say this, the high and increasing level of fraud is affecting my own, and I suspect others, view of new programs like health care. I am really starting to feel like every program, no matter how well intended, should be voted down due to the potential stealing it will enable, and that is the wrong way to have to think.

Anyway, what about the market? The market seems to be (possibly) entering somewhat of a trading range, as we are back down below the 1100 level in the S&P. Also, the volatilities are continuing to show an upward sloping skew that would indicate the market somehow feels that there is market volatility down the road. For us, and especially those that are in the more aggressive trading groups, it means that there is less opportunity to initiate new positions. As you well know, I like to initiate positions that have us buying further out options and selling nearer term options against them as a hedge. I am very reluctant to do that if I am forced to buy a higher volatility than I am selling. That corresponds to what we call “negative edge” and it increases the need to be absolutely right for the position to be profitable. I especially like it, and activity in your accounts have reflected it over the years, when we can buy relatively low volatility and sell high in the same spread. That gives us “positive edge” and greatly increases the chance of success even if our original opinion proves faulty. It also impacts cash put to work in the PIP program, as I do not really like paying a 26 volatility for our long puts while getting a 21, say, for our short calls. There can be times to do that, but generally I like as much advantage as I can muster when initiating a position. I like where our positions are right now, fairly tightly protected with some upside potential, and with some cash available if something good shows itself. We still may do a little more to get us a little longer, but I think it would be a good idea to wait to see where this Dubai thing takes us before jumping in.

Stay tuned as we are planning a January PIP Seminar!