Heroic solitary security analysts, like Warren Buffett and Benjamin Graham are figures of the past — vestiges of forgotten times when capital markets were much, much simpler than today.

	The solitary, heroic security analyst is long gone

Actually, Messrs Buffett and Graham moved away from classic securities analysis about two generations ago, as bond yields began to surpass stock yields and as control of most public corporations began to slip from individual shareholders and owner-managers, passing to mutual fund administrators and hired executives.

Mr. Buffett continued in finance in the holding company business (Berkshire Hathaway), while Professor Graham entered academia and life as a financial guru.

What changed since the time of Graham & Dodd?

Security analysts in the Buffett mold spent their days analyzing financial statements.

Most companies were relatively simple, with few subsidiaries and a single line of business.

	A business an analyst could understand

One could tear into a financial statement, rip out some critical ratios (turnover of receivables and inventories, net working capital, return on equity, dividend payout, etc.) and then visit the company.

Touring the factory floor, chatting with workers on the assembly line, and having lunch with the sales manager, a good analyst could ascertain whether the balance sheet appeared to reflect reality, while gaining an insight into the future of the venture. With a little commonsense and willingness to go against the crowd, the solitary hero financial analyst could do quite well.

This was before the days of off-balance sheet financing, outsourcing of production to distant lands, just-in-time inventories and supply-chain management, and the subordination of individual companies to extremely complicated groups of interlocking financial interests.

Why financial statements have become less relevant

Although the SEC and the US Congress have not yet caught on, the organization of modern economic endeavors has far out-stripped the ability of accountants to present easily comprehensible financial statements that provide sufficient information to understand the strengths and weaknesses of a particular security.

The following diagram, is a vast simplification of the actual structure of many major international corporations traded on world stock exchanges today.

	Economic groups easily confound modern accounting

It shows how willy-nilly interlocking relationships, often ultimately circular in nature, based on equity holdings, service contracts, off-balance sheet agreements, and memoranda of understanding, transcending international boundaries, with legal ties passing through non-disclosing offshore financial centers, can easily turn the financial statement of a single unit in the network (say the green box), into an irrelevancy.

A chart showing the myriad contractual and ownership relationships of a major international institution, like Citicorp, would likely cover an entire football field in a spider-web carpet of infinitely complex ownership and contractual relationships that defy attempts of accountants to present a “consolidated” statement of what, in essence, is beyond the capabilities of dual entry bookkeeping.

A decade ago, when I was advising securities regulators in Southeast Asia, my clients would come to me with charts far more complicated than the diagram above, with questions like, “Is Mr. A an affiliated person of Mr. B”, or “If Mrs C gives information about company X to Mr. D, is this insider information?” The answers were never obvious. Complexity can quickly trump the best regulation intended to protect investors.

The criticality of non-accounting information

Although, in the wake of a financial catastrophe, like the failure of Enron, Worldcom, the Crash of 2008, or the Madoff Ponzi scheme, the US Congress likes to call for tighter accounting standards or more effective oversight by market regulators, the truth is that those inclined towards bad behavior in securities markets can dream up complex schemes faster than regulators can write rules.

	Complexity of design may amount to deception

Until a law is passed banning complex financial arrangements or requiring approval for new products and financial operations — as is done in the pharmaceutical industry — accounting information will become ever less central to the task of analysis of investment opportunities.

• Auction rate securities: Analysts at Standard & Poor’s gave most issues of auction rate bonds investment grade ratings because they were asking the wrong question, “What is the risk of default of this bond?”. The better question would have been, “What is the risk that this bond will become illiquid?”, but the analysts were not being paid to answer that question and investors lost billions.
• Behavior of investment management: Billions of dollars were lost in the Ponzi scheme because neither the SEC nor advisors channeling client funds to Bernard Madoff asked the simple question, “Is it reasonable for one man to have sole custody and discretion over billions of dollars of other people’s money, with the oversight of only a tiny auditing firm operating out of a store front in a New York suburb?”
• Rogue operations: The failure of Barings Bank a decade ago and the crisis at AIG following the Market Crash of 2008, both illustrate the fact that in large complex organization, a rogue operator or unit, a tiny part of the whole, can put an entire huge organization at risk. Details that escape the auditor, like a break-down in internal controls in a far off banking unit in Singapore, or unclear, non-standard terms of over-the-counter derivative contracts, not mentioned in the annual report to shareholders, can be instrumental is collapsing a giant financial institution.

Rethinking the analyst’s job

The old-fashioned, heroic security analyst, working alone in a dark room with a stack of annual reports, in a snow-bound house in Omaha, far from Wall Street, is less likely to solve investment riddles today, than fifty years ago.

The first problem of today’s analyst is the sheer volume of information that is freely available over the Internet.

A search for the term “Citicorp” in the SEC files turns up over one thousand documents. The same term on Google, turns up almost one million hits.

Somewhere in this vast sea of information may be the “smoking gun” that either reveals a security as an outstanding opportunity or unacceptable risk.

It is clear that this data should be “mined”, and that the task is greater than any individual can handle alone.

	Capital Market Wiki --- a work in progress

The analyst of the 21st century must be ready to engage in collaborative research. The solitary hero-analyst can not handle the job alone, anymore.

The solution to the problem lies in modern knowledge handling technology, including OSINT techniques, crowdsourcing, wiki software, and capital market taxonomy.

Capital Market Wiki is a project that addresses this issue.

I’ve written on this a bit in previous articles:

See: Crowdsourcing investment research: opportunities in OSINT and Free information and the Efficient Market Hypothesis and Crowdsourcing investment research: Capital Market Taxonomy and Innovation in investment research; dealing with free information and Modern technology for institutional investment research and New technology in open source investment intelligence

This topic is extensive.

I’ll have more to say, later.

Like all proposals that come from the Obama administration, details of the President’s multi-trillion dollar public health care plan are murky and shrouded in controversy.

However, the essentials are simple:

	Will doctors survive Obamacare?

1. The number of people to be covered by health insurance will expand to cover the entire population, including illegal immigrants.
2. The overall cost of health care will be dramatically reduced. How this will be achieved is not fully disclosed.
3. It takes about ten years to create a new doctor, starting from the initial career choice on graduating from high school.
4. Health care is a service industry and the principal costs are the salaries and earnings of doctors and nurses.

The implications of this plan are straight forward.

If the demand for health care services is to be artificially stimulated by government mandate and if it takes a decade to increase the supply of doctors needed to meet this demand, in the immediate future, to achieve the President’s goals without further inflation of health costs, either health care must be rationed by the government, or doctors and nurses must earn less for less service — or both.

Average earnings of doctors will fall

Because it is not politically expedient for the politicians to tell grandma that she can’t have that hip replacement, rationing health care — especially for over-indulgent Baby Boomers entering their golden years — will be a non-starter, in the early years.

This means that doctors who come to depend upon the Obama health care system, will face a sharp decrease in income and increased bureaucratic paperwork to justify even that.

	Will it still pay to study anatomy?

Medicine will become a far less attractive profession. The Obama plan does not contemplate reducing the fees of their favored constituency, lawyers that sue doctors for malpractice.

Extremely high entry costs (ten years of education and internships), together with diminished returns, will provide strong disincentives for the creation of new doctors.

Normal attrition and retirement will reduced the supply of medical professionals further.

The result will be fewer medical professionals serving more people. Care must eventually be rationed and doctors must earn less.

It’s just textbook supply and demand, operating under artificial restraints.

Some patients will do quite well, thank you

Some Americans will continue to receive excellent health care under the Obama plan:

	The rich and powerful will do just fine

1. The very wealthy. Even in under-developed countries with dicey health care systems, the rich do OK. Factory owners in Indonesia fly to Singapore for routine checkups. In Brazil, the well-to-do go to private doctors rather than to government-run hospitals.
2. The very powerful. President Obama, his family and friends, will not have to face the indignities of public health care, just as they are able to avoid the public school system brought down by the unionized teachers that they support.
3. The unionized proletariat. Government and private sector workers, protected by union contracts and exemptions hidden in the Obama plan, will be given preferences, not on the level of the very rich or powerful, but better than the adoring masses that ushered Obama into office.

The doctors, nurses, and hospitals that cater to the rich and powerful will survive the Obama plan.

The rest of the profession will either fall prey to what I call the “electric wheelchair syndrome”, described below, or will face restricted circumstances.

Some years ago, I visited Brazil and found doctors driving taxicabs in Rio de Janeiro, victims of the government health system. Many moved to the United States.

The electric wheelchair syndrome

Any economic system that is regulated not by the free market, but by government rules, will contain loop holes to be exploited by clever entrepreneurs.

Medicare is a case in point.

In Florida (and perhaps in other places), local television is swamped with advertisements for electric wheelchairs. The pitch is quite simple:

If the wheelchair seller is not able to get Medicare to pay for that electric wheelchair you think you would like to have, after having said that you qualify for the benefit, you’ll get you wheelchair for free!.

	Electric wheelchair and beneficiary

Every year, the ads show the building of the wheelchair seller getting bigger and bigger.

A trip to Disneyworld reveals squadrons of obese wheelchair drivers, scooting around the theme park, competing for parking spaces at the most popular attractions.

Obviously, someone has figured out how to get Medicare to approve requests for electric wheelchairs. Maybe a doctor owns the wheelchair company. Maybe a Medicare official gets a commission. Something is going on. Even President Roosevelt didn’t have an electric wheelchair.

If it’s not electric wheelchairs, it will be something else. Regulations create loop holes to be exploited and if people can figure out how to make money on a loop hole, it will be done.

Some clever doctors will learn to extract cash from Obama care and will do quite well. It will all be quite legal. It just won’t be medicine.

Obamacare is not necessarily inflationary

The projected trillion dollar costs of Obamacare may not eventually be realized, not because of cost savings resulting from efficiency, but rather because of rationing of services.

If there are not enough doctors and nurses to attend the expanded demand for services, inevitably rationing must be imposed. The supply of services, rather than demand, will be the limiting factor.

With rationing, money is simply not spent as fast as it might be otherwise. If money is not spent, and if costs are kept artificially low by cutting doctors fees, inflation will be contained.

This is great news for the rich and powerful people who will continue to enjoy the best health care service on earth. It is also great news for investors (except for investors in hospitals and medical facilities).

Doctors will move away from medicine to more lucrative pursuits — like selling electric wheelchairs.

Meanwhile, grandma, who voted for Obama, will just have to wait for that hip transplant.

We won’t have to consult the Consumer Price Index to know when the much feared Obama-inflation monster has finally arrived to devour what savings we have left. All that will be necessary will be to look at the average yield on short-term money-market funds.

	.

In the 21st Century, money market funds are now the center of the short-term banking system — and are largely unregulated by the US monetary authorities.

In Q1 2009, total assets of money market mutual funds, according to Fed flow of funds table L.206, were $3.7 trillion, 5.6 times the $666.6 billion in checkable demand deposits with commercial banks. Demand deposits are now only 5.1% of commercial bank liabilities.

The MMF: the non-bank bank

Although money market funds are classified as securities and regulated by the SEC, rather than by the banking authorities, they are, in fact, a banking operation. They take money from “depositors”, with the understanding that it may be withdrawn at any time, on demand, by checks that are cleared along with drafts on commercial banks.

	.

The “depositors” in money market funds do so with the understanding that they will be able to withdraw the amount deposited, plus a variable rate of interest, whenever they feel like it.

Of course, technically, “deposits” in a money market fund are not a liability of the fund, but rather equity in the form of shares, usually with a net asset value adjusted daily to a one dollar benchmark by issuing additional fractional shares in the amount of the interest earned in one day.

Like commercial banks, money market funds invest “depositors’” money in short-term loans, usually commercial paper.

However, unlike commercial banks, money market funds do not have to maintain reserves with the central bank, nor do they normally set up reserves for doubtful receivables. Furthermore, unlike commercial banks, their “deposits” are not guaranteed by the government (until the Crash of 2008).

For practical purposes, a money market fund is the same as a bank. A fund borrows short and lends long and promises to pay depositors on demand, principal plus interest.

An unfair advantage

Because money market funds do not maintain reserves with the central bank, they are able to pay substantially higher interest than available on demand deposits at commercial banks. Nor do money market funds normally offer drive-in tellers, night depositories, or the myriad other services that regular banks offer depositors.

In 1968, when the first money market fund was set up in Brazil, during the years of the economic miracle, the Minister of Finance quickly realized the dangers of this new instrument and slapped strict restraints on marketing.

However, three years later, when money market funds were introduced in the United States, the authorities did not perceive any potential problems, mainly because the instrument seemed to fall under the jurisdiction of the SEC, rather than the banking authorities.

In order to see systemic risk in a new product or operation, regulators must have multiple jurisdictional understanding, reponsibility, and authority. Because the SEC saw only the risks of investors losing money, they could not perceive the larger threat to the banking system.

The problem was, however, that banks, particularly savings banks, had legal limits imposed as to interest that could be paid on deposits. As the Jimmy Carter stagflation grew during the 1970s, and as asset-backed securities were invented to provide a virtually unlimited supply of short-term debt securities to the new money market fund industry, the position of savings banks became untenable.

Since savings bank assets consisted of long term mortgages with fixed interest rates, they were not able to raise rates on deposits to match the rise in short-term interest spurred by the inflation.

The result was the “great sucking sound” (as Ross Perot might put it) of savings bank deposits being transferred to money market funds.

	Inflation's vortex. A great sucking sound.

Because American officials were not as smart as their Brazilian counterparts and were hog-tied in a tangle of conflicting regulatory jurisdictions, the savings banks were ultimately destroyed by unfair competition from money market funds, leading the savings and loan crisis of the 1980s and 1990s.

Short-term interest rates and inflation

When the first money market fund was set up in Brazil in 1968, the internal rate of inflation was about 25%. Six month to one year commercial paper, in retail denominations, yielded rates of from 28% to 32%. Interest on bank deposits were limited by usury laws.

.

As a result, the first money market fund was able to offer rates on what essentially were demand deposits, of about 24% — double commercial bank rates — and still charge an annual “administration” fee of 4% on fund assets! Because there are no capital requirements to manage a money market fund, the potential return on the equity of a money fund manager is virtually limitless. The only limit is marketing ability.

In these extreme circumstances, it is no wonder that the Brazilian authorities saw the dangers posed by the money market fund instrument and drastically reduced marketing options.

Years later, after the prudent ministers of the Brazilian miracle were gone, and as money funds had become popular in the US, the Brazilians copied the American example and allowed money market funds to flourish.

After the Crash of 2008 and the 2009 budgetary madness of the Obama-Pelosi-Reid team, we now look forward to the possibility of inflation rates in the United States to which most Americans have never been exposed. In this context, the regulatory status of money market funds becomes extremely relevant.

With inflation of 25% a year, or more, and with money market funds not subject to bank reserve requirements, the Federal Reserve will be unable to control the money supply.

The reason is simple:

1. At 25% a year inflation, long term bonds become worthless. To cover deficit spending, the Treasury will only be able to sell short term bonds. This will push short-term rates to extreme levels.
2. As the Treasury issues checks to pay for the Obama “spending is stimulus” plan, the money will leave commercial banks to be deposited in money market funds, which will have no reserve requirements and therefore will be able to pay much higher rates of interest than commercial banks.
3. As interest rates rise on short-term paper soar, money market funds will be able to charge higher and higher “administration” fees. With the demise of Glass-Steagall, banks will place depositors money directly in money market funds they control.
4. Without the control of reserve requirements on money market funds, the “multiplier effect” of these virtual banks will kick in, as the public moves money from one fund to another, and inflation will get really serious.

What this means is that unless the government cracks down on money market funds, placing them under virtually the same regulatory regime as commercial banks, including the ability to set reserve requirements that can be adjusted upwards as needed, the United States will be at risk of much higher inflation than many can imagine today.

So, what we must watch is the regulatory moves made on money market funds. So far, from the anti-inflationary point of view, noises made by the administration are not encouraging.