BOSTON—A little-known Republican shook up the balance of power in Washington by winning a U.S. Senate seat in Massachusetts, a result that imperils President Barack Obama’s top legislative priorities and augurs trouble for his party in this year’s elections.

Cast beneath the front page story, these three bullets, pointing to stories I’m not linking here:

• Independent Voters Abandon Democrats
• Americans Weary of Government Intervention
• Democrats Set Plan to Pass Health Bill

It could just be me, but one of those items doesn’t belong with the others, and in fact represents the root problem for which I hope Senator Brown’s election is the first solution step.

The Democrats, in sole control of the levers of government, are committing slow-motion suicide, and don’t seem to care. I hope, for the sake of the country, the sake of our political system, and frankly, the sake of the Democrats, that they don’t make the ignorant mistake of trying to whistle past this particular graveyard.

Oh, and Martha/Marcia (Go Patches! Do that dynasty proud!) Coakley? Perhaps the worst, most tin-eared, foot-in-mouth candidate ever.

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Stable home prices may be overrated. Every month that there is an artificial barrier that prevents real estate prices from falling faster is a month that the market does not reach rock bottom, and rock bottom prices are what eventually bring buyers into the market. Real estate prices are being destroyed by the current “hundred year storm” in the industry and buyers will find the bargains irresistable, even if mortgages rates are not at a historic low. The government can draw out that process unnecessarily instead of standing aside as it takes it natural course.

The taxpayer will write a check to Fannie Mae and Freddie Mac in the name of keeping real estate prices from falling. That taxpayer might buy a house with his check, but the government is keeping home prices too high.

Everyone (well, some people anyway, the ones who were paying attention, not including those who were playing the game) worried about the clearly-building bubble in the real estate market. Poof! Turns out it was real.

And now, those who should have taken action (Greenspan’s folksy alleged wisdom notwithstanding) are blowing as hard as they can, attempting to reflate the bubble. Marvelous.

In 2004, Stephen Roach was quoted: (Economist)

…the chief economist at Morgan Stanley, has long argued that the Fed is a “serial bubble blower”. Its cheap money is stimulating another round of irrational exuberance. America’s property market certainly looks pricey: the ratio of house prices to incomes is currently at a record high, and about a fifth above its 30-year average.

He was right then, and it’s still true today. Clearly, they’re at it again.

To avoid gloom and doom? Too late – that already occurred, and should have been left, in late 2008, to burn itself out by whatever means necessary. Stretching the pain of the adjustments over the next 30 years is not preferable to allowing the markets to have regained equilibrium on their own.

To assure affordable housing for everyone? As any economist, observer of recent history, or both should be able to point out, the fact that everyone with a pulse was allowed to purchase a home, even when many would clearly have been better served to rent or live with their parents, did nothing but goose the price of real estate to the point where it not only became unaffordable to all those this magical low price was supposed to help, it ALSO cratered the financial system.

Great work, Fed/Treasury (but I repeat myself). Give yourselves a pat on the back. And then get the hell out of the market. You’re killing us.

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—– Quote —–
“President Barack Obama’s economic recovery program saved 935 jobs at the Southwest Georgia Community Action Council, an impressive success story for the stimulus plan,” the Associated Press reports.

Hey, great news! Just one little problem: “Only 508 people work there.” The story continues:

The Georgia nonprofit’s inflated job count is among persisting errors in the government’s latest effort to measure the effect of the $787 billion stimulus plan despite White House promises last week that the new data would undergo an “extensive review” to root out errors discovered in an earlier report.

About two-thirds of the 14,506 jobs claimed to be saved under one federal office, the Administration for Children and Families at Health and Human Services, actually weren’t saved at all, according to a review of the latest data by The Associated Press. Instead, that figure includes more than 9,300 existing employees in hundreds of local agencies who received pay raises and benefits and whose jobs weren’t saved.

You read that right: Civil servants got pay raises, and the Obama administration claims credit for “saving” their jobs:

Officials defended the practice of counting raises as saved jobs.
“If I give you a raise, it is going to save a portion of your job,” HHS spokesman Luis Rosero said.

Aren’t you excited to think that these people may soon be in charge of your health care?

—– End Quote —–

One of several possibilities seems obvious here:
1. These guys are idiots
2. These guys think we’re idiots
3. Both

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The short-selling ban that is in place from yesterday through October 2 (or later) is an abomination. Not only is it bad policy in an absolute sense, it’s made worse by the cynical hypocrisy of those who begged for it to be put into place.

It’s one thing for an amiable boob like Patrick Byrne to whine about short-sellers and how they’re killing his company. I’m willing to give Byrne some small measure of benefit of the doubt, since finance isn’t his claim to fame. But when the chairmen of the Federal Reserve and the SEC, along with the former CEO of Goldman Sachs, now Treasury Secretary, start whining out of the same hymn book, they’re not serious, not believable, and are clearly playing to the idiots in the audience.

Short selling, the act of selling shares you don’t own, with the expectation that you’ll be able to buy them back later at a price equal to or lower than the price at which you sold the. Simple, really. And it’s got nothing to do with wanting to harm the company whose shares you’ve sold short. It’s simply an expression of opinion that the shares are overvalued, for one reason or another.

Selling short, then spreading false rumors against a company is an offense for which one can be pursued in a court of law. Funny thing, though – not selling short, then spreading false rumors against a company is also an offense for which one can be pursued in a court of law. If you do the verbal algebra, it becomes clear that selling short has nothing to do with the illegality of false rumors. And the law recognizes this – selling short is, in anything approaching sane regulatory times, not illegal at all.

Selling short can occur for many reasons, in many different contexts. Everyone I’ve read focuses on bets that a stock might or should go down. I’ll go you one better. For instance, to take a random example, let’s just say that the Investment Banking group in Goldman Sachs’ Chicago office were doing a public offering of stock for a client.

Such offerings typically include an underwriter’s option for an additional 15% of the shares being offered as “the green shoe”, to cover overallocations. Since an investment bank typically has no interest, and certainly has no requirement, to be an owner of stock in the companies for which it provides underwriting, if an offering looks successful, and the demand is high enough to make exercising their option for the “green shoe”, the normal action an investment bank takes is to sell short a number of shares equal to the amount of the green shoe, knowing that they’ll be able to replace those shares with the additional 15% for overallocation. If the stock has run up in the aftermath of the offering, better still – they can sell stock that’s more expensive than the offering price, knowing full well that they can replace it at the offering price. But at a minimum, they already know the price at which they can buy the stock in the future, so this isn’t a bet that the stock will go down.

Treasury Secretary Hank Paulson, having been the head of investment banking for Goldman Sachs’ Midwest Region (1983-1988), then managing partner of the Chicago office, followed by co-head of IB for the entire firm, can safely be presumed to know all of this.

Neither SEC Chairman Cox and Fed Chairman Bernanke has any experience in capital markets, but neither of them can assert ignorance of the role that short selling plays in the market.

And who’s been calling loudest for limitations on short selling? The investment banks, solvent and formerly-solvent:

Lehman:

Lehman executives complain that they have been singled out by hedge fund investors that are short selling — or betting against — their stock, and Mr. Fuld has called senior executives at competitor banks demanding that their employees stop criticizing Lehman.

Morgan Stanley:

The mood was far different at Morgan Stanley, which lobbied vigorously for the ban on short selling. The bank’s shares shot up 21 percent, to $27.21, on Friday. Analysts said the reprieve might be only temporary, though, because the firm’s business model still requires a big balance sheet and core base of deposits for financing.

Goldman Sachs:

…the SEC is this afternoon holding a meeting to “determine if they need to take further steps to curtail what both Mac and [Goldman Sachs CEO Lloyd] Blankfein characterize as improper short selling that is really causing damage to the share price of Morgan Stanley and Goldman Sachs.” Blankfein also spoke with Cox to complain of short selling of their stock, as did New York senators Chuck Schumer and Hillary Clinton, according to Gasparino’s sources.

And so on. Fannie Mae, Freddie Mac, Bear Stearns, AIG, and a host of others, all now functionally dead as public companies, claimed loudly, with much gesticulation, that short sellers, not their crappy business models or abysmal risk management, were the reason for the drops in their stock prices.

New York’s AG Andrew Cuomo:

Likening such traders to “looters after a hurricane,” New York Attorney General Andrew Cuomo Thursday said his office is investigating “a significant number” of complaints about improper short selling in shares of Lehman Bros., AIG, Morgan Stanley, Goldman Sachs and other financial stocks.

Cuomo said his investigation would use the New York state Martin Act, which subjects violators to criminal as well as civil penalties, to combat the illegal practices.

“The markets need to be stabilized,” Cuomo said. “And one way to bring about such stability is to root out and deter short-selling that is based on the spread of false information.”

Sorry, Spanky – you left one class of people out: Weather forecasters before a hurricane. Deter short selling based on the spread of false information? Sure – go ahead, although there are already laws in place to do that, so knock yourself out enforcing them, with my blessing and encouragement. Disallow short selling itself, as though there’s no valid reason for a non-rumor-spreading trader to do? Utterly stupid. And impressive only to the self interested (the banks) or ill-educated (all other non-bankers who’ve complained about short selling).

Applauded only by the greedy & ignorant? Must be a great plan, then. I’ll take all this addle-pated nonsense about “gangs of people getting together to sell shares of a stock” seriously when several things also happen:

• The same idiots decide to go after “gangs of people getting together to buy shares of a stock” (Cramer – I’m looking at you and everyone like you).
• Someone explains to me the difference between a short seller selling a share of stock and an actual holder of the stock selling a share of stock. The market neither knows nor cares.
• Which raises the question of what’s next? Disallowing down-ticks entirely? Disallowing any sale of the stocks of the protected 799 alleged-financial companies? Even by widows and orphans who actually hold shares? What is this, the Hotel California?

“Issue Two” (please read that to yourself in John McGlaughlin’s voice, for best effect)


The details of the proposed bail-out for the deadlocked financial system are not yet clear, but one among them, the aforementioned short sale ban, has already torched a number of market participants otherwise undeserving of being torched.

Full disclosure: I’m one of the undeserving torchees. While I’m still up more than 25% this year, three weeks ago I was up more than 70%, and my results have suffered from the several recent bouts of unhinged euphoria-despair-euphoria. Lehman’s going bust, AIG might follow? Market crashes. Government may bail out AIG? Market recovers. Government may bail out AIG (yeah, I repeat myself)? Market crashes. Government might bail out the entire decomposing carcass of the financial system, but just for good measure, decides to stop the recognition, if not the reality, of the rot by banning short sales? Market recovers.

And Monday, when the reality of the market-saving gambit by the SEC/Fed/Treasury becomes more clear, the market will definitely either crash or soar. It surely won’t stay still, because whatever plan is mooted, someone will love it, hate it, or see a conspiracy to mulct the taxpayers for the benefit of Wall Street and the Main Street banks.

Put me squarely into the later two categories. For years, the financial sector has been spinning ever-more complex products for sale both the individuals and institutions, and has been paid handsomely for creating the damage from which they now suffer. Please also have a look at the story at Gawker, “It’s The “Absurd Financial Product Some Rich Person Actually Bought” Contest!”, from which the Blue Cow Faceplant picture above came.

Any solution that fails to meet the following criteria, in my opinion, should occasion the modern-day equivalent of street protests with flames and pitchforks in Washington DC:

• Any institution who decides to place “toxic assets” into government care should pay a severe penalty, in terms of the haircut they take on the deal. For instance, when Merrill Lynch sold CDOs to Lone Star, they got 22 cents on the dollar, and provided 75% financing. (see also this, from Fortune). This sets a nice benchmark. An upper benchmark, that is.
• The issue that Cox/Bernanke/Paulson are trying to solve isn’t to restore the banks’ balance sheets to their former luster and size, but instead to remove the shame and stink of the reams of bad assets contained therein, which cause all of the market participants to mistrust each other. They each know how badly they’ve damaged their own financial positions, and what they’ve not yet disclosed or taken write-downs on, and they assume, probably correctly, that all other participants have done the same. Nobody wants to be the first to drop their drawers and embarrass themselves. They should all be forced to fully disclose their positions in everything, market reaction be damned.
• The result of this will be the shrinkage or disappearance of many or all such participants, and any who stay out of the rescue pool will either already be transparently clean and problem free, or will be ostracized like the financial lepers they are.
• This shrinkage of concentration in the financial services market should not only be accepted, it should be encouraged. Many small firms, each small enough to fail without adverse consequences to the economy as a whole, are far preferable to a handful of mega-firms without whom, we’re encouraged to delude ourselves, we can’t exist.
• The final package must be free of the standard Washington give-and-take back-scratching, the sort that has nothing to do with the problem at hand. West Virginia, for instance, doesn’t need any more federally funded assets with Robert Byrd’s name on them, his certain protestations to the contrary. They should get in, fix what needs fixin, and get the hell out.
• The final package must, absolutely must, contain provisions to counteract moral hazard. In particular, these would include things like the warrants for 80% of AIG shares that go with the government’s backstop financing for the ailing insurance behemoth. If AIG’s holders are able to replace the financial backstop (as well they might, given a credit system which again works as it should), then they can prevent exercise of the warrants. But if they can’t, their equity goes poof!, just as it should. Some similar disincentive to sloth must be a precondition for participation on the part of all those who dump toxic assets into whatever cauldron the government provides. Something like Bill Ackman’s prescription for Fannie and Freddie wouldn’t trouble me at all.

I’m old enough now that I should be well beyond hearing simple phrases made up of well-known words but that cause me to say “Yeah. That’s what it is!”. But “privatized profits, socialized losses” is just such a phrase that’s crept into the common lexicon in recent months. For all I know, it’s been in wide use for many years, and I just missed it.

But that’s the problem that the US must avoid, otherwise we’ll turn into a shell of our former economic selves. And we’ll deserve the ignominy.

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First, there was the Emperor AG and Premier Governor of New York, Eliot Spitzer, getting his, and a reasonable person could hope he’s got still more coming to him, given the pompous hypocrisy of the crusades on which he embarked before his fall.

Today’s news, however, on Alaska’s Ted Stevens, is equally satisfying to read. Charged with public corruption, and seemingly certain to be found guilty given the brazen and entitled nature with which he sought the spoils of his office, the only shame here might be that, at 86 years old, he’s unlikely to be incarcerated for the term he deserves, if at all. He’s been a national joke, most recently at least, for the Bridge to Nowhere pork fiasco, and his indictment cements his status as an embarrassment to Alaskans, Republicans, the Senate, and Americans.

Most people think that there’s a general presumption of innocence in America, but that’s only true within the court system, and in the issues that surround the court. I’m happy to report that my odds of serving on any jury of Mr. Stevens’ peers are zero, and I’m neither the judge nor the prosecutor in his case, so I owe him no such presumption.

He’s dirty, and the only thing better than having him indicted and removed from office would be to step back forty years, and take he and all other grandees of his sort out of the political process entirely. Glad-handing thieves, selling the citizens’ best interests for their personal aggrandizement, are among the lowest forms of life in America.

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I also asserted that most of the tools available to the Pakistani government for reacting to the problem are available in other markets, and that they generally don’t work, because they don’t actually address the problems, instead focusing on the symptoms.

Finally, I mentioned in passing that the solution that seems most likely to help resolve matters can be found in monetary policy. It’s the one that everyone has avoided, though they surely have thought of it. Fed chairman Bernanke has begun nibbling around the edges of monetary policy, but may not, based on recent past history, be able to pull the trigger on any actual implementation – huffing and puffing that you really dislike inflation isn’t the same as, say, Paul Volcker (with the full support of Ronald Reagan, and not caring at all what Wall Street wanted) jacking interest rates to the moon and killing inflation dead.

Monetary policy is a complex subject, and one at which I’d hardly claim to be an expert. The meat and potatoes are simple – make money too easy to borrow and people will treat it cheaply, spend it too easily, and invest carelessly (think “drunken sailors”). Result? A debased and devalued currency. Follow that with a commodities supply/demand crunch, and the devaluation of a currency can spiral, as crucial commodities, priced in dollars, increase in price due to the decreases in the real value of the dollar, encouraging (if the Fed is gutless enough) further loosening of credit, further real devaluation of the currency (now itself effectively valued in “barrels of oil”, “tons of iron”, “Euros”, &c).

Silly “stimulus checks”, of the sort pushed by Congress this year and shamefully not vetoed by Mr. Bush, had a one-time effect on spending, which makes sense – they were a one-time return of tax dollars, disproportionate to actual taxes paid, and could reasonably be expected by anyone with a memory extending longer than six months ago to have had precisely the anemic and worthless effect that they did. Undaunted, Speaker Nancy Pelosi thinks (or at least claims to think) that all we need is $50 billion more in such stimulus. Which proves at a minimum only that her memory extends even less into the past that the rest of the nitwits who voted for the somewhat politically astute, but utterly economically absurd notion of the initial stimulus.

Politically astute – why only “somewhat”? Because one-time stimulus is politically astute only if one is trying to impress those who lack mental acuity. On one view of how we might measure such a thing, elementary statistics, something close to 50% of all people have less than average intelligence. Or, as George Carlin put it:

Think of how stupid the average person is, and realize half of them are stupider than that.

Of course that one-time stimulus seems helpful, at the time, and if you don’t think too deeply about it, to have someone handing out money. Better yet if it’s someone else’s money. And if it’s done in a crafty enough way, those same people who don’t think deep thoughts might be gulled into missing the realization that if the money’s better in our hands than the government’s during these current difficulties, why not every year?

But enough of that – I could go on in (small) circles about monetary policy, but have already devolved into fiscal and tax policy, so to keep this from turning into more of a rant than it already is, I’d like to tie this post back to the one from yesterday, and I have found the perfect foil with which to do so.

In an article in the Saturday July 19, 2008 Wall Street Journal, the always-readable James Grant, of Grant’s Interest Rate Observer asks “Why No Outrage?” (subhead: “Through history, outrageous financial behavior has been met with outrage. But today Wall Street’s damaging recklessness has been met with near-silence, from a too-tolerant populace”)

No, he’s not suggesting that we man the barricades, pitchforks in hand, Molotov cocktails at the ready. But he does make the easy case that things haven’t worked out as well as hoped in our current system of carrots, sticks, checks, and balances.

“Raise less corn and more hell,” Mary Elizabeth Lease harangued Kansas farmers during America’s Populist era, but no such voice cries out today. America’s 21st-century financial victims make no protest against the Federal Reserve’s policy of showering dollars on the people who would seem to need them least.

Long ago and far away, a brilliant man of letters floated an idea. To stop a financial panic cold, he proposed, a central bank should lend freely, though at a high rate of interest. Nonsense, countered a certain hard-headed commercial banker. Such a policy would only instigate more crises by egging on lenders and borrowers to take more risks. The commercial banker wrote clumsily, the man of letters fluently. It was no contest.

The doctrine of activist central banking owes much to its progenitor, the Victorian genius Walter Bagehot. But Bagehot might not recognize his own idea in practice today. Late in the spring of 2007, American banks paid an average of 4.35% on three-month certificates of deposit. Then came the mortgage mess, and the Fed’s crash program of interest-rate therapy. Today, a three-month CD yields just 2.65%, or little more than half the measured rate of inflation. It wasn’t the nation’s small savers who brought down Bear Stearns, or tried to fob off subprime mortgages as “triple-A.” Yet it’s the savers who took a pay cut — and the savers who, today, in the heat of a presidential election year, are holding their tongues.

Possibly, there aren’t enough thrifty voters in the 50 states to constitute a respectable quorum. But what about the rest of us, the uncounted improvident? Have we, too, not suffered at the hands of what used to be called The Interests? Have the stewards of other people’s money not made a hash of high finance? Did they not enrich themselves in boom times, only to pass the cup to us, the taxpayers, in the bust? Where is the people’s wrath?

(continues)

No calls for violence there, no stoning or burning either. But he does wonder why people just accept this asinine state of affairs.

So do I.

Half-baked solutions, designed to appeal only to the stupid, will not solve the problem, and will actively and quickly make it worse. Freely available money, ala Bagehot, but at near-punitively high interest rates, can make it possible for the blockages in our financial system to work themselves out.

The alternative, where the Fed (and the implicit “Bernanke Put“, and let’s not forget the “Greenspan Put“, either) continues to think that Wall Street is more important than Main Street, hasn’t worked and won’t. (Candidate Obama has used that Wall Street/Main Street formulation in his stump speeches; the difference between his use and mine might be that I actually understand what it means, and why it’s a crucial failure in our system).

It’s probably best that I’ve never been a combat medic, because I think that a quick bleed, with full understanding of where the blood is likely to gush, is preferable to a five year drip, or worse, a five year internal bleed of reasonably knowable but still-indeterminate origin.

And if that bleed (the quick gusher) occurs on Wall Street, then so be it. Chasing the dollar down to $250 per barrel of oil/$250 per metric ton of iron ore/$0.25 per Euro seems hardly worth it, when the sole reason for doing so is to continue the pretense that what’s good for Wall Street is good for America.

The rot’s got to stop before the economy can properly heal. Half-measures will continue not to do.

See also:
   WSJ – Stupidity and the State, and Stupidity and the State, Part II
   NYT – Given a Shovel, Americans Dig Deeper Into Debt

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Clues can be found in a Marketwatch article from yesterday evening:

EMERGING MARKETS REPORT
Investors riot in Pakistan as market tumbles

Benchmark down for 15th straight session; loses 27.5% this year so far
By Polya Lesova, MarketWatch

NEW YORK (MarketWatch) — Popular anger over tumbling equity prices erupted in Pakistan on Thursday, underscoring the difficulties regulators face in attempting to prop up falling markets as turbulence in many of the world’s financial markets continues unabated.

The turmoil in Pakistan comes at a time when several emerging markets are considering market stabilization measures, while regulators in the United States are moving to limit short selling and speculation in the oil market.

Regulators in China have signaled their intention to stabilize the local market, which became the worst performer among global markets this week. India has suspended futures trading in several commodities.
In Pakistan on Thursday, more than 200 protestors attacked the Karachi Stock Exchange, the country’s main equity market, and demanded a temporary closure of the market to curb further drops in share prices, the BBC reported.

Smaller protests took place in Islamabad and Lahore.

[continues]

For reasons not so easy to articulate, I find it breathtaking that such a reaction makes any sense at all to these aggrieved investors.

Capital markets wizards at work

Are the investors in emerging Asian markets really so unsophisticated (Albania comes to mind, among others) that they’ll buy anything, at any price? I suppose so – this has happened throughout history, in Asia, the US, and elsewhere. But in the majority of those other cases that come to mind, when it all goes wrong, the populace doesn’t seem to automatically think that all can be made better by burning buildings down, do they?

Not only are such reactions destructive (to property and to society in general), they’re also of no use in resolving the problem.

Some folks, I suppose, should be completely protected from themselves, and prohibited from taking actions they might later regret. Much the same, I further suppose, as special needs kids are sometimes not allowed out of the house without a styrofoam-lined helmet.

Such paternalism would be troubling to those of us who feel able to take responsibility for our own actions, but, by definition, we’re also not the sort of people who’d think burning down the stock exchange (which, really, is just a building, and had no effect on the stupid prices people were willing to stupidly pay for securities, right?) was a great idea. The Pakistani authorities’ “styrofoam helmet” for the markets includes circuit breakers to dampen price volatility, short-selling limitations, and a “market stabilization fund”. Much the same set of tools has been used by other governments over the years, with little beneficial result.

The connection made in the original article to US commodity (primarily oil) markets and allegations of skullduggery in shorting of financial behemoths such as Fannie Mae, Freddie Mac, Lehman, et al is apt, though the differences between the two situations are meaningful. When you add in the other bugbear, the rapidly deflating asset (real estate) bubble, within the US, the focus is on systemic risk (in the financial behemoths) and pure political grandstanding (regarding the oil futures markets and residential real estate), but surely, a minimal number of buildings will be burnt to express disappointment.

The point the two situations have in common is the ultimate futility of efforts to game the market excessively, from either the regulators’ or the speculators’ side of the table. Market stabilization fund? Ask George Soros what he thinks of the efficacy of such devices.

Market volatility curbs? They are a band-aid solution, i.e. no solution at all. If the limits are hit on a given day (particularly down days), the selling frenzy can just as easily be pent-up until the next day. And the day after. In cases where limits on asset price increases would be helpful to halt bubbles of speculative excess (tech stocks in the 1990s, real estate more recently), the proper method isn’t price movement limitations, but instead should be monetary, in the form of interest rates and margin requirements.

Where does it all end? Not in violence, and not in wanton destruction of real property. Too many more gimmicks, such as stimulus checks designed to gull the electorate into thinking all’s well, or handouts to flagrantly uncreditworthy home buyers, and the road to the end of this mess gets steeper and more slippery. Oddly enough, that monetary hammer mentioned above, in the form of interest rates, can play a big part in solving the current woes, though it won’t solve them quickly.

Devaluation of the dollar is the flip side of cheap credit, and while dollar devaluation is a subject for another day, reducing speculative excesses by making money more expensive to deploy in speculation, whether it be in commodities, real estate, or the financial markets seems likely to be the only path out of the current unpleasantness.

If that turns out to be the case, many will feel the pinch. Fortunately, the stoics who make up a lot of the American population, sophisticated or not, seem more likely to suck it up, endure the pinch, and exit the other side better off than they are today. An optimist would further hope that this was all done without the government stupidly taxing the starch out of the economy, but if the government does so, perhaps the government after them will repair the damage, and reap the delayed benefits.

Regardless of government policies, the flame-throwing non-sophisticates of the Pakistani markets may not fare better nearly as soon.

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About an hour before Wall Street closed for the week, I got a call from an old friend who’s an equity analyst for an east coast hedge fund. He wanted to know whether it was possible that there was any truth to the rumor he’d heard about a merger in the waste industry.

That merger? Republic Services and Allied Waste Industries.

While it turns out that I should have just said no, that I had no idea, and moved on to other matters, I first told him that I’d heard no such rumor. Not that all, or any, rumors run through me before they’re generally available to the rest of the populace, mind you, but I do have some experience in the waste industry, including some related to M&A activity. So his question wasn’t out of place, my specific ignorance of this rumor notwithstanding.

I thought about it for a bit, and then, while allowing that of course anything’s possible, told him that this was highly unlikely, for a lot of reasons. For instance, have a look at these two track records:

One of those two report cards is decidedly not like the other, yet this is billed as a “merger of equals”. Hey – we’re in the 21st Century – so we’ve got to say whatever makes the kids feel good about themselves, I guess. Everyone gets a trophy! I realize, of course, that they’re roughly equal in market cap, with Allied being the bigger of the two by several hundred million dollars, but that market cap was smaller than RSG’s before the rumor of a deal leaked out, and with good reason.

Feel free to have a look for yourself – RSG has outperformed most of the waste industry by a noticeable margin in the last five years.

Some time ago, when Republic began its steady climb, Jim O’Connor, the CEO, articulated a strategy that said, in essence, “There’s a limit to the value of pure size in the waste business”, and he took the company off the hamster-wheel of non-stop M&A which had gripped the entire environmental services industry in the 1990s. He paid down debt, and in 2003, the board began paying a dividend, one which has grown just as steadily as has the stock price you see above.

Allied? Not so much in the way of fiscal discipline. They’re big, and have always had visions of growth, but have never, not since their initial “big” acquisition (Laidlaw?), many years ago, had a balance sheet that would be rationally rated as anything but highly leveraged. Even though a properly run company in the waste industry can generate a lot of cash (between big capital expenditure cycles, anyway), it’s proven impossible for Allied to meaningfully hack their debt load down to size.

There are good companies in the industry, there are average companies, and then there are bad companies. The three good ones are Waste Connections, Waste Management, and Republic Services. Allied is just average, and only looks average if you choose a short enough timeframe for analysis. Long term, it’s been a disappointment. BFI Canada is also average, but as a unit investment trust, pays a decent dividend, and has some excellent assets. (The bad ones, in case you’re curious, include Casella Waste, Waste Services, and the boondoggle known as WCA Waste Corporation)

So anyway, my thesis to my friend went, O’Connor and RSG decided long ago that since the waste business is, in its essence, a local business, it should be run that way, and stockholders would applaud. Applaud they have, and they’re better off for it.

By comparison, I continued, Waste Management (WMI), the granddaddy of the industry, and a fine company in its own right, maintains a pretense to being a single company, but they could just as easily be split into five pieces. The benefits that come from the corporate shared services (finance, brand building, HR, IT, &c) might not be as easily justified as they are in, say, a manufacturing environment, one with fewer ultimate end-customers. The lost touch with the needs of local market customers and the decisions that are made corporate-wide but which don’t fit in all markets/jurisdictions can make the all-encompassing shared service model look silly. Forcing square decisions into the occasional round hole of a local market might make the mandarins at Corporate happy, but make the customers unhappy. The corporate headcount & other overhead required to implement choices that don’t necessarily scale to infinity can sometimes be money ill-spent.

At a certain size, then, a case can be made that the whole is worth less than the sum of its parts.

And that’s the hymnal Republic Services has sung from for many years, carrying the tune admirably.

So, as I told my friend, their chasing a larger company, one structurally weaker than themselves, seemed ill-advised, and I figured that Mr. O’Connor would avoid doing such a thing.

Shortly after we were done talking, however, a teaser for this story hit my inbox, via the WSJ news alert service:

DEALS ALERT
from The Wall Street Journal.

June 13, 2008

Republic Services is in merger talks with Allied Waste Management, according to people familiar with the matter.

If completed, the deal would combine second and third largest trash haulers in the U.S., creating a formidable rival to U.S. market leader Waste Management. Should a deal come together, the companies are expected to bill the transaction as a “merger of equals.”

It will likely be structured as a purchase of Allied by Republic worth around $7 billion, or greater than $16 per share. Exact details of the offer — such as whether it is for cash or stock — are still unclear.

As a side note, there is no company of which I’m aware called “Allied Waste Management”, and I am just guessing when I assert that Thomson Financial is the culprit for this faux pas. Witness this snippet from a Forbes.com story on the deal, as it was written on June 13, 2008:

SAN FRANCISCO (Thomson Financial) – Republic Services Inc. (nyse: RSG – news – people) and Allied Waste Management Inc. (nyse: WMI – news – people) late Friday confirmed that they are in discussions regarding a possible merger.

So, yeah, there was a bit of confusion there, but it doesn’t change the fact that I was totally wrong.

Luckily, there wasn’t any particular fallout from my erroneous conclusion, aside from a bit of extremely mild embarrassment on my part. (That’ll teach him to ask me for such advice!) My reasoning remains valid, even though the results of that reasoning were useless.

Operating under the assumption that RSG really is driving this bus, perhaps their decline in revenue growth (3% in 2007, vs. 7%-8% in recent prior years) has caused Mr. O’Connor to go looking for a fixer-upper. And the fixer-upper he’s currently chasing is a tired horse with 2%-3% historical revenue growth, a debt-heavy balance sheet, and a sclerotic corporate culture. Allied’s got some good operating assets and good people, (along with some less exciting entries on both ledgers, as could be expected in any big company) but has taken a decidedly go-slow approach toward many important corporate activities, including resolving the capital structure that has arguably limited their growth.

Perhaps joining up with RSG can solve all that. And perhaps it cannot.

Mr. O’Connor is one of the best in the business (and made an unfortunate exit, on his own terms, from WMI 10 years ago, otherwise he’d probably be running that company now) but RSG has no meaningful recent experience at acquisition integration, nor does Allied, and RSG is buying into a company with more placque in its corporate veins than befits its own culture. If consummated, this merger could get more interesting than either party would prefer.

Or so I still believe. Even though I was wrong and should have invoked the Nancy Reagan Defense.

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The focus of the story was on a small Washington DC based fund that’s done poorly of late.

Blue Fund Group is having a rough year.

Blue Investment Management LLC, the fund group’s Washington, D.C., investment adviser, has liquidated Blue Small Cap Fund, which managed less than $1 million.

It is now in the process of changing the name of its Blue Large Cap Fund, which has a little more than $10 million in assets, to, simply, Blue Fund. So far this year, that fund has underperformed both its large-cap growth category and the Standard & Poor’s 500-stock index, according to Chicago investment-research firm Morningstar Inc.

Odd, that. Not the results, particularly, but the fact that the story appears at all. “What’s the problem?”, I wondered, and what makes this tiddler of a fund worthy of coverage in the WSJ? I read on…

In addition, in a rather odd development, $9.5 million of the large-cap fund’s assets were invested recently by a trust that has said it may hedge its bets on some of the fund’s holdings.

Blue Investment Management was formed in 2006 to invest in companies that “act blue” and “give blue,” those that engage in practices consistent with progressive values and give the majority of their political contributions to Democratic candidates.

Following a proprietary managed index of U.S. companies, the large-cap fund invests in “blue” companies in the S&P 500 index, while the small-cap offering had invested in “blue” companies in the Russell 2000 index.

Additional info, according to an April 2007 article at Morningstar:

The Blue funds (Blue Large Cap and Blue Small Cap), launched late last year, invest in companies that give a majority of their political contributions to Democratic candidates and organizations, in addition to passing various standard social screens. There are no funds focused specifically on Republican-leaning companies, though the Free Enterprise Action fund (FEAOX), launched two years ago, promotes free enterprise and opposes shareholder resolutions that might dampen companies’ profitability, including most SRI-type proposals. Also, the Camco Investors Fund (CAMCX) specifically uses socially conservative screening criteria, as do several of the religious funds we looked at in our earlier column, notably the Ave Maria and Timothy Plan funds.

Quintuple odd.

No “Republican-focused” funds? Because nobody would buy them, I presume, preferring instead to just focus on companies well-situated to make money.

Aside from the fact that the new biggest investor in Blue Funds may choose to hedge its bet, taking contrary positions to that of its now-majority owned fund, the slack-jawed investment thesis behind the fund is a real eye opener.

How is it, I wonder, that someone was able to correlate the political contribution tendencies of companies, and then to target them for investment? Wait – I’m not done yet: Of course it’s simple, though a bit labor-intensive, to do such a thing, but having done such a thing, how could someone have done such a bang up job of choosing a thesis with a correlation apparently approaching -1? And then put client money behind such a spastic idea? And still slept at night?

It’s possible to grotesquely overthink investment theses, even when, unlike the strategists of the Blue Fund, you leave political proclivities out of the mix. Running such a tiny fund, and apparently running it nearly into the ground, causing closure of the “small cap” side of the fund, abandonment of the “large cap” moniker on the other half, and causing the new largest investor (sort of) to consider hedging its exposure to your attempts at splitting atoms with your mind (and political views) seems like an item one would leave off one’s resume.

The same goes for all “Socially Responsible Investing”, if you ask me, not that you did.

Unless, of course, the goal isn’t to make money at all.

Granted, it’s been a tough year in the markets, but it’s not been impossible to make money. For comparative purposes, one of the things I do on a daily basis, with a very small portion of my time, is participate in running a proprietary hedge fund. The assets under management seem similar to those reported for the Blue Fund family by the WSJ, yet our focus is solely on making profits. And overall, we’re up more than 40% so far this year.

It’s not impossible, and properly done, it’s not even particularly difficult. The difference might be that there’s no ideology behind our investment choices, and no attempts at claiming correlations that don’t exist in the real world.

There’s nothing wrong with social, or political, responsibility. Neither has much of anything to do with investing, however. I don’t invest to help those in need or to advance a political point of view – I invest to make profits. To help those in need, I give to the Red Cross. And to advance a political point of view, I vote.

In investing, as in many other things, avoiding confusion about why you’re doing it is a fundamental prerequisite to being even mildly competent.

Tags: Blue+Fund+Group, Ideology, Investing

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