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Yet another economic update

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Our financial markets update to clients (September 19, 2008):

The usual caveats apply. Everyone’s financial situation differs. Consult your own advisor or do your own research. We have been wrong before.

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We apologize for the barage of emails but we’ve experienced a decade’s worth of financial events in a week. We will give a quick rundown of the government’s actions in the last 24 hours and then discuss what “safe” means.

FDIC-ish Protection for Money Market Funds
The US government will seed a guaranty program to provide insurance for money market funds, similar to the way FDIC provides protection for bank deposits. Details are scant. One key difference will be that the insurance is optional but available to any fund that agrees to follow rules about portfolio investments and pays an insurance premium. Another is that there does not appear to be any cap on the value of insured holdings. A fun trivia fact for you: the money for this initiative is from the same fund Bill Clinton and Robert Rubin used to bailout Mexico during the Peso crisis in 1994.

Troubled Asset Relief Program (“TARP”)

Don’t you love the cute acronym – “TARP”? The US government has announced a huge fund to buy up dodgy mortgage-backed paper. They are pitching this as a similar program to the Resolution Trust Corporation (RTC). The RTC was established to slowly liquidate all the illiquid assets the US government got stuck with when it took over bankrupt savings and loan associations (“S&Ls”) during the 1980s. It was considered a big success because the RTC eventually recovered a lot of money for the US taxpayer by patiently selling off investments over time. The new program is different in that they will buy assets from investment funds and financial institutions that are still in business. This could be a stealth bailout if the government pays more than market value for the investments or a great deal for taxpayers if they buy decent but illiquid assets at bargain basement prices from desperate sellers.

Short-sale ban on all US financial stocks

Holy catfish. In a blatant attempt to prop up stocks (temporarily) and put the blame for recent events on those evil no-good short sellers, the SEC banned short-sales on over 800 different stocks. This looks like a deferral of pain rather than an avoidance of pain and poses a severe disruption in the normal trading of stocks. It is hard to find a metaphor that can express how unprecedented this action is. We actually sent an email to our congressman complaining about it.

What does “safe” mean?

That is a great question and gets to the heart of risk management. There are many types of risk and putting together portfolios of risk that have the highest expected returns given the maximum amount of loss our clients are willing to accept is our business.

Today, we want to talk about two specific kinds of risks. The first kind of risk is that you don’t get the cashflows you were expecting. The second risk is what we will call opportunity risk. You will still get back the cashflow you were expecting but, after you agree to the terms of an investment, a better one becomes available.

An example. You lend someone $100 and they promise to pay you 10% interest in a year plus pay the loan. Tomorrow, they are willing to pay 11% interest. Even though your investment is “safe” in the sense you will still get $110 in 364 days, your investment has lost value because of opportunity risk. If you were to pawn off this loan to someone else, they would only pay $99 for it.

Almost all investments on the planet have opportunity risk. Treasury bills have opportunity risk. Your two year cell contract with AT&T has opportunity risk.

Sometimes we are aware of it, sometimes not. When we buy a bank CD, there is opportunity risk. The banks, however, are allowed to tell us that our $100 CD is still worth $100, even when higher CD rates are now available and you would have to pay massive penalties to get your money out early. This makes them feel good and us feel good.

The money market funds were created to give everyone this same feeling of serenity. Even when things move a little bit (up and down) they always cost $1. We can get out the exact same amount of money we put in, any day. The reality is that the investments that a typical money market fund own still have some opportunity risk and move a little. Not a lot, but some.

In the old days, while the investments in money market funds had a little bit of opportunity risk, they had minimal cashflow risk. We got concerned earlier this year when we saw all sorts of strange asset-backed securities and heavy weightings towards financial institutions appearing in portfolios. We were especially concerned that if one fund had losses from cashflow risk, there would be a panic, mass liquidations and increased opportunity cost losses across the board. Fast forward to Monday and this fear became reality.

When we said that not all money market funds were safe, we meant “safe” in the way money market funds have been sold – as never varying in value. They are safe in the sense that there is no chance you lose all your money or even most of it.

Maybe it is time we all started recognizing that risk is an inherent part of our lives and that our focus should be on understanding the risk and making active decisions about how much and what kind of risk to take.

Elizabeth and Jessica

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