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Retirement Planning for a New Grad

by Robert G. Yetman, Jr.

You did it. School is finished, and you finally have that prized sheepskin in hand. You even managed to land that first good job.

Congratulations! You’re well on your way to retirement!

Wait, what?

While having enough money for a secure retirement may be the last thing about which you’re thinking right now, it is the single most important financial goal you will ever have. Accordingly, the sooner you get started, the greater the chances that you will achieve it.

For young investors, the power of compound interest is one of the key components to the success of long-term investing efforts. An early start to the process of reinvesting earnings, or earning interest on interest, allows you to meet your eventual goals without the stress and sacrifice demanded of folks who begin investing for retirement later in life. Because of compound interest, a 23-year-old who socks away $350 a month into an account that posts an average return of 7% per year will have a little over $1 million at age 65…and of that million, only $176,000 will represent principal.

What’s more, you can further maximize the power of compound interest by investing your paycheck under a tax-deferred “umbrella” that allows your invested monies to grow unencumbered by tax consequences to interest, dividends, and capital gains. For most people, this usually means going with a company-sponsored plan, usually a 401(k), or the do-it-yourself option, the Individual Retirement Account (IRA).

Is one account better than another? The advantage of the 401(k) is that it comes with (much) higher annual contribution limits – for people under 50, $18,000, vs. $5,500 for an IRA. Many companies also offer the unbeatable benefit of company matching, where your job matches your own contributions to the plan, up to a certain percentage of your annual salary. Additionally, 401(k) contributions are made with pre-tax income.

As for IRAs, while contribution limits are lower and there is no matching, you can set up the account at basically any kind of financial institution. This includes discount brokers, where the breadth of available investment options – stocks, mutual funds, exchange-traded funds (ETFs), and more – provides a distinct benefit over the more limited vehicle choices in a 401(k). Also, contributions to traditional IRAs are tax-deductible, subject to certain restrictions.

Look for any matching available from your new employer, and, if it’s there, you’ll want to focus first on a 401(k) up to the point where the matching stops. Even if your employer does not match what you put in dollar-for-dollar (and many do), a 50% match means that you’re earning a 50% return on your contributions from the outset.

If your company plan happens not to offer any kind of matching, your best approach will usually be to maximize the IRA first, and then fund your 401(k) with any money you still have available. The reason IRAs are better in this case has to do with the enormous variety of investment choices – your company 401(k) will never have as many options as you’ll find in an IRA.

In a nutshell, then, matching (company plan) is best; wide variety of investment choices (IRA) is next-best; and tax-deferred growth, a standard feature of both accounts, is always good.

If your investing plans do include an IRA sooner or later, a discount broker will usually be the best place to open one. Discount brokers afford you the best of both worlds – a great many investment options, as well as the most competitive fee structures, in comparison to other institutions.

There is a wide variety of discount brokers from which to choose. As a new investor, pay close attention to the choices that provide you with the best and lowest-cost options for investing in mutual funds and ETFs, investment vehicles that won’t demand as much of your valuable time to oversee. Both TD Ameritrade and Charles Schwab, for example, offer a veritable universe of commission-free ETFs and no-transaction-fee mutual funds.

So, the good news is that you graduated, and the better news is that you landed that first job. Maybe the best news of all? Reaching the first two goals has provided you with the opportunity to begin your journey toward building a meaningful retirement portfolio, something that may not seem all that urgent now, but will, one day, be among the most important of things.

Investing in Physical Gold Through Your IRA

by Robert G. Yetman, Jr.

Investor interest in gold and other precious metals is always higher during periods when people are particularly concerned about the stability of global economies…and, principally, that of the nation in which they reside; it has been that way since the advent of modern economies and the now long-established era of central banking systems. That said, the most devoted of “gold bugs” never see a bad time for having money set aside in the asset, and now, given the likelihood that more distressed economic conditions will persist in many developed nations for years to come, even those who have assumed a more traditional investment posture, historically, are giving serious consideration to making gold a standard portfolio asset, including investing in the metal through an Individual Retirement Account (IRA).

While it is no great challenge to invest in gold-representative securities products…like stocks of mining companies, and gold mutual funds and ETFs…in an IRA, what does it take to buy and hold the actual physical metal inside of an IRA? While gold-related stocks and funds can be transacted with ease within an IRA that is available through any securities brokerage, in order to purchase the metal for your IRA, there’s a little more to the process, including the fact that the administrative “overseer” of your IRA, the custodian, has to be more specialized than the IRA custodians with which you may be more familiar.

I’m referring here to something called a self-directed IRA. Self-directed IRAs are different from other IRAs in that the custodian provides for the account owner the ability to invest in a greater breadth of asset types than those normally available in a “regular” IRA. Ultimately, IRA administration is about recordkeeping, and self-directed IRA custodians have simply decided to go after a segment of the investment market that wants access to asset classes that, while allowed by the IRS, fall outside of what most custodians are set up to maintain.

Self-directed IRA custodians provide a tax-sheltered home for such diverse holdings as real property, a private business, tax liens, notes, and, of course, precious metals, subject to certain conditions. While theoretically, just about any store of value could be held as an asset inside of an IRA, there are some explicitly disallowed by the IRS; the list of prohibited investments for IRAs includes life insurance, alcoholic beverages, tangible personal property (furniture and clothing, for example), and just about anything typically thought of as a collectible – art, rugs, antiques, and the like.

You’ll even find metals on the list of proscribed investments, but there are exceptions, which is why you’re able to put money into physical gold at all through your IRA. Presently, you can invest in gold, silver, palladium, and platinum inside of an IRA, and the metals have to be configured as bars, rounds, or coins, depending on the metal. Beyond these general guidelines, the IRS has strict standards of fineness that must be met in order for the metal to qualify for purchase in an IRA. In the case of gold, bars must be pure to 24 karats, or 0.995+ fineness, and coins must also be pure to 24 karats (again, 0.995+ fineness), although there is an exception granted for the 22 karat American Gold Eagle.

Bars vs. Coins

While gold metal choices are in the physical form of either bars or coins, let’s talk about coins, specifically, for a bit, because some of those available for purchase do not meet IRS standards for purchase in an IRA.

We talked about metal purity a minute ago, and that’s what really makes the difference to the IRS. Gold coins that do not meet the requisite purity standards are those marketed principally for their numismatic value, as collectibles – remember, collectibles, per se, are off limits to IRAs. To the IRS, the overriding standard of what qualifies an approved metal for an IRA is its currency content. In other words, the IRS doesn’t care…and, by consequence, doesn’t think you should care…about how limited a run of a particular coin design might be; what matters is that the chunk of gold you’re buying, regardless of the actual physical shape or uniqueness of the “edition,” is basically all gold, and that for those for which there is some definable numismatic value, said value remains subordinate to the currency value.

If you have a particularly affinity for any of the IRA-acceptable coins, then that’s just fine, but if you don’t really have a preference as you begin the process of establishing a gold IRA, and all that matters to you is the currency value of your metal, then you’ll likely prefer bars, and the reason for that, very simply, is cost.

Even if you know practically nothing about the production processes associate with gold coins and bars, your intuition probably informs you that there’s more to creating coins than there is to creating bars, and you’d be right. Coin production can be expensive, and that cost is passed along down through the chain to you. By contrast, the pouring of bullion bars is a much simpler, more straightforward process, resulting in a lower cost. For example, 10-ounce gold bars can be purchased for about two percent above spot price, whereas I’ve seen new 2016 American Eagle gold coins go for a premium of anywhere from five to 15 percent, although a five to eight percent premium is more typical.

Let me say a few things about proof coins and fractional coins, which are both subject to strong marketing by the retail gold industry. Proof coins are any of the wide variety of “special edition” coins you commonly see marketed on TV and the Internet. Those interested purely in the collectible value of coins may value proof coins at a premium, but markets based on numismatic value, rather than currency value, are wildly unpredictable. While some proof coins meet the IRS’s standards of acceptability for inclusion in an IRA, the premium you’ll pay for the touted collectible value, in addition to the currency value, can be significant, and the unpredictability of collectibles markets means that the hoped-for benefit may not be there when you want to sell.

Fractional coins are so called because they consist of varying fractional amounts of an ounce. For example, in addition to a full ounce, American Eagles can be purchased in denominations of a half-ounce, one-quarter ounce, and one-tenth of an ounce. They’re fine, but the premiums over the spot price tend to be higher than they are with one-ounce coins.

Ultimately, if you’re serious about investing in gold with your IRA because what is most important to you is straight currency value, bars will likely remain your best bet, in a net sense, but note that I’m speaking generally here; there are plenty of coins that are IRA-eligible, and you may prefer those for a particular reason. For example, if you envision the possibility of a future existence where even basic transactions will take place in the form of precious metals, then coins may offer an additional benefit of practicality because of the inherently smaller denominations that naturally coincide with that physical form, and so paying a higher markup for those might make sense to you.

Getting It Done

The Players

The first step to opening your gold IRA is to familiarize yourself with the key entities (besides yourself) that must work together to facilitate your account opening. There are three:

  • The self-directed IRA custodian. The job of the custodian is to act as the IRS-approved account “umbrella” under which your actual investment assets exist. The custodian does not sell you your gold, nor does the self-directed IRA custodian store your gold. This is an important distinction about which you should be clear, specifically because of the use of the word custodian. Custodian, in this context, does not refer to the physical location at which your goal is secured, but, rather, to the entity responsible for properly administering your IRA. In the end, the custodian is basically all paperwork; important paperwork, to be sure, but the point is that they will never see your physical gold on their end.
  • The dealer. The gold dealer is the place from which you will actually purchase your gold. To clarify, they have nothing to do with the administration of your IRA, and will not be serving as the storage facility of your gold.
  • The depository. The depository is the where your metal is vaulted. Again, while the depository will have custody of your physical gold, it will not be the custodian of your IRA. I know I keep hammering away at that, but it can be a point of confusion for a lot of investors.

The Process

As far as the process of opening a bona fide gold IRA is concerned, it’s relatively straightforward, but with the three entities involved, and each playing an essential role in and of themselves, it’s easy to be unclear about what to do first.

To really break things down, the process will be conducted in two steps. The first is to perform your due diligence, to research and decide on just what firms will be serving as your dealer, depository, and IRA custodian. The second step will be to engage in the transactions in the proper order, which is easy; plus, no company of substance that is acting either as a dealer or custodian will do anything to put you in a compromised position with the IRS.

Choosing a Dealer

When it comes to choosing a dealer, you’ll want to take some time to ensure you’ll be transacting with one that has an excellent reputation.

The most important consideration for you, outside of the basic business reliability of the dealer, is the price you will be paying for your gold. As long as you’re paying no more than a couple of percentage points above spot for your bars, and somewhere in the range of five to eight percent for your coins, you should be fine, as far as price is concerned.

At the Consumer Affairs website, you’ll find an article with a pretty fair list of gold dealers, some of the names of which you may recognize, but do not see this as the final word in lists of gold dealers.

In the end, gold is a commodity…maybe the ultimate commodity…so outside of price, as well as the reputation/reliability of the dealer, there’s not going to be a lot for you to consider.

One thing: your new IRA custodian may prove to be of some assistance with the selection of a dealer. There’s going to be a fair chance that the custodian will have a list of gold dealers with which they’re familiar, and that can be a good resource for you to evaluate, as well.

Choosing a Depository

The depository you select will be the actual home of your gold, so you’ll want to be sure you’re happy with it…and part of that will have to do with the options you choose that pertain to the precise manner in which your physical property is maintained in the vault.

There are two particularly important storage-related terms with which you want to be familiar when discussing depositories – allocation and segregation. Allocation refers to the way depositor gold is stored as a matter of accounting; segregation refers to the way in the gold is physically stored.

Both are significant, but allocation, in the sum total of things, is going to be a little more meaningful to you. Confusing the matter is that sometimes the terms are used interchangeably, even by gold professionals, but they do not refer to the same thing, exactly.

Gold that is allocated exists, from an accounting standpoint, specifically, solely, and separately…in the name of the owner; gold that is unallocated is pooled…again, as a function of accounting…with the assets of other, unallocated gold depositors. Additionally, unallocated gold is reflected on the balance sheet of the depository, meaning it is a part of the depository’s own assets and liabilities, and can even be loaned out by the depository.

In other words, think of unallocated gold in the same way you know your money on deposit at the bank to be situated. In that case, while you have an account in your name, and, under normal conditions, the bank will hand you a check out of “your account” when you show up to make a withdrawal, the money is pooled with all other depositors’ money, from the standpoint of practical application, and the bank can, and does, loan it out. Additionally, if the bank runs into trouble, your money may be at risk.

While allocated gold is, by implied definition, held off balance sheet, I would ask any depository you’re considering to confirm that both of those conditions will exist on behalf of your deposit – that it will be allocated and held off balance sheet.

Next is the matter of segregation, which refers not to the way your gold is stored from an accounting standpoint, but how it is physically stored. Segregated deposits are kept separate from those of other customers, while non-segregated deposits are vaulted together.

Segregation is not quite as important as allocation, but it will be the preferred method of physical deposit for many gold buyers. I say “not quite as important” because it is still possible for gold to be both fully allocated and non-segregated. The reason someone might opt for non-segregation is, simply, cost. Because gold is not being separately vaulted from everyone else’s, the storage costs are lower. Think of it as you would the difference in cost between a private and semi-private hospital room.

Practically speaking, and bottom-lining it, if you show up at the depository to collect your gold that has been held fully allocated and fully segregated, you will receive back the exact same metal(s) that were originally deposited, while unallocated and unsegregated account holders will usually receive the same kind of metal that was originally put on deposit, but not the very same metal, itself. Furthermore, as explained a minute ago, unallocated metals are subject to the depository’s risk in the way that allocated metals are not.

If your metal happens to be allocated but physically stored as unsegregated, you may not receive back your exact same deposited metal on withdrawal, but you will not bear the depository’s financial risk while it is vaulted. This is why I said earlier that the matter of allocation is going to be a little more important to your financial security, overall, than that of segregation.

As far as segregation goes, for many, as long as they are getting back the same kind of metal they put on deposit, that’s good enough. For example, anyone’s $1 bill spends the same as the $1 bill you have in your pocket, and so most people would not care if they traded $1 bills with their neighbor. However, some gold investors do not feel quite the same way about the metals they purchase. 

Bottom line, for the safest, most secure configuration of your gold deposit, you want it to be fully allocated, off balance sheet, and segregated.

All of this said, the manner in which your gold is stored, from accounting and physical standpoints, is by no means the only consideration when it comes to making depository choices. The biggest and best depositories, which are the only places to which you should entrust your gold, are all going to have state of the art storage facilities (including vaults constructed to standards that meet or exceed those established by the Bank Protection Act, as well as those of Underwriters Laboratories),  outstanding security, plenty of all-risk insurance coverage, and all of the features you would want in a depository.

Although depositories with well-known names like HSBC Bank USA, JP Morgan Chase Bank NA, and Brink’s are approved to handle a gold IRA, others, like CNT Depository in Bridgewater, Mass., and Delaware Depository in Wilmington, Del. are popular with IRA investors and custodians, as well. In the minds of some gold buyers, one particular advantage offered by CNT and Delaware is that each is physically located a fair distance away from any of the major U.S. cities that, unfortunately, are more likely to be terrorist targets, or that may be more significantly affected by a natural or man-made disaster. Additionally, it is worth noting that Delaware Depository is the largest depository in the United States outside of New York City.    

(Please note that none of the depositories named in this article is indicated here as a recommendation, but, rather, merely as examples of IRS-approved depositories that are generally well-known throughout the precious metals community.)

One other thing – you may find that some self-directed IRA custodians, about which we’ll be talking more in just a minute, will either require, or strongly suggest, that you use a depository with which they have been working exclusively. If you, through your own independent research, determine that you are fine with that depository, great…but bear in mind that there are custodians that allow you to choose whatever depository you want to use. While I mention this in terms of this discussion on depositories, it also has bearing, obviously, on your selection of a custodian, as well.

Choosing a Self-Directed IRA Custodian

You’ll want to do some legwork here, and much of it in the form of fee comparisons. I don’t wish to suggest that you “commoditize” the IRA custodians, and look only at fee structure, but when investors sour on a custodian, it’s typically because they feel they’re paying too much for the administration of their accounts. Here is a comprehensive list at the website of IAG Wealth Management (a firm that has nothing to do with this article, and with which I have zero connection) of self-directed custodians, one the firm itself decrees as “available for public use.” However, I would do additional Internet searches on the basis of “best self-directed IRA custodians,” that sort of thing, and massage all of the information you find to begin narrowing down a custodian selection.

Something else: The quality of the customer service you receive from a self-directed IRA custodian is essential. Although I mentioned that people who leave one custodian for another do so because they decide that they don’t like what they’re presently paying in fees, some do leave because they’re unhappy with the customer service provided by their present custodian. When I was active in the securities industry, I would sometimes have run-ins…or would hear from clients who had unfortunate experiences…with the customer service departments of select self-directed IRA custodians.

Here’s what I’m getting at, on the subject of service: As you’re initiating dialogues with various custodians, pay attention to the speed and quality of the responses to your various queries. Overseeing non-traditional IRA assets, while something that should be natural to anyone in the business of doing that very thing, is still something that falls far enough outside the box of many investment professionals that it’s not uncommon for customer service representatives at custodian locations to have their hands full – some may be new, and still working their way through the learning curve. It’s not a warning sign if you have to be placed on hold while the representative with whom you’re speaking has to confer with someone else in order to answer your particular question, but the point is that you should, ultimately, be getting knowledgeable, detailed assistance, and the overall experience should be excellent. As you’re working your way through the custodian selection process, keep that in mind.

Again, as you’re working to find a dealer, depository, and custodian, it does not matter with which you speak to first. You will likely start out having ongoing telephone and email exchanges with representatives from several of each, as you begin gathering up information, and that’s just fine. 

Note that in this era of increased synthesis of investment entities, it is now common for each of the role players here…dealers, depositories, and custodians…to have resource lists and information about each other. For example, a dealer with which you speak may have a “suggested list” of depositories and/or IRA custodians, a depository may have information on dealers and custodians, and custodians…well, you get the picture. The point is that, nowadays, in the interest of facilitating a client’s intended investment transaction, as well as given the nature of the required interrelationships between the entities, it’s no big deal for one to have a lot of information on the others. However, while that can help make doing research a little easier, be sure that you’re still engaging in your own independent study.

Once You Have Your Roster Selected

With your three entities chosen, the hard part is over, and things get easier from here.

As noted, while you may well be having multiple interactions with the dealer, depository, and IRA custodian during the information-gathering phase, the general process to consummating the transaction is to first open and fund your IRA account at the custodian you’ve selected. Once the account is open and money is available, the actual transaction can occur in a timely fashion. You will also formalize the relationship with your chosen depository at this time, so that they will expect the impending arrival of your metal on behalf of your IRA.

However, as previously mentioned, the depository relationship may prove to be a function of the relationship with your custodian, or otherwise “go through” your custodian, particularly if you end up choosing a depository with which your custodian regularly deals.

From this point, you will clarify just what it is you will be purchasing from the dealer, so you will next reach out to them. The dealer will provide you with a price quote, as well as the information needed by your custodian to complete the transaction – you may be asked to sign a trade confirmation that you will then forward to your IRA custodian.

Your custodian will then ask you to sign their version of an “authorization to purchase” form, which serves as their formal instructions from you to buy the gold. The custodian will then transmit the funds, as well as a packing slip and/or shipping instructions for the depository, to the dealer. The dealer will complete the purchase transaction, pack up your gold, and ship it to the depository. You will receive notification once your metal has been received by the depository.

That’s it.

Be advised that the earlier on in the process you establish your IRA, the more useful you may find the custodian representatives to be in facilitating the transaction, all the way around. In other words, while what is being outlined here suggests you will be doing a good deal of the legwork yourself, the fact is that any questions you need answered, as well as any help you need with any part of the process, should be something for which you can rely on a quality custodian. This is why it’s important that you do a good job vetting your IRA custodian, and going with one that you can determine has a lot of experience with precious metals IRAs and that has an excellent client service record.

Some Final Details

It’s important to remember that your gold IRA is an IRA first; the rules that govern IRAs remain paramount, regardless of what it is in which you’ve decided to invest the monies inside of your IRA. Sometimes, self-directed IRA account owners get a little confused about “acceptable behavior,” because the assets they buy are so much different from what they’re used to holding in an IRA.

For example, some gold investors are puzzled as to why they can never take possession of their bars or coins during their working years or while they wish to retain the tax-deferred integrity of the IRA umbrella. If an investor were to withdraw his physical gold from the depository at which it is held, that would be considered a distribution, for tax purposes, and, just like the IRA you might have at a bank or brokerage, any distribution you take before age 59 ½ is subject to IRS penalties, and may also be counted as ordinary income in the year you withdraw the gold, depending on the type of IRA you have. Of course, withdrawals made after age 59 ½ are not subject to penalty.  

When it does come time to take distributions, you may do so in either the form of the physical metal or cash; you will simply inform your custodian of your preference, and they will assist you with arranging the transaction. Of course, if you want the money, the process will include liquidating (selling) the metal through a dealer…again, while it remains inside of the IRA…and then the custodian cutting you a check for the amount of the distribution.

If you want to open your gold IRA with a transfer or rollover from an existing retirement plan, that is no problem. The tax-deferred retirement plan processes and rules remain universal, without regard to what it is, precisely, you’re using your monies to buy. For example, if you have a 401(k) that you want to move from a previous employer, or an IRA at a brokerage that you’d like to now use for the umbrella for your tax-deferred physical gold investing, that is no problem. You can open your self-directed IRA using the proceeds from the transfer or rollover of an existing IRA or other qualified retirement plan, subject to IRS regulations as well as the terms and conditions of your present plan and custodian. In the case of a direct transfer (which is preferred, because at no time do you take possession of the money), your first move is to open the self-directed IRA, and then arrange for the transfer through the new custodian.

If you want to move the money in the form of a rollover, a situation in which you actually receive the check for the retirement plan proceeds from your previous custodian, and have up to 60 days to redeposit the money into another IRA or qualified plan before taxes and penalties, as appropriate, might ensue, you could get away without having the self-directed IRA account open before receiving the dough; you just have to make sure that you’ve set up the new account, and funded it (that’s the really important part) with your proceeds by the time the 60-day window closes.

You’ll notice I did not address the question of if investing in physical gold through your IRA, or at all, is a good idea. For purposes of this article, I did not want to get sidetracked into that discussion. The truth is that people who believe in putting some or all of their investment monies into precious metals tend to view those assets as being fundamentally different from anything else in which they might invest, and are even guided by a philosophical, trans-secular outlook that shapes how they see life itself. That is, they tend to see having money socked away in gold as something that transcends a typical investment perspective, and speaks to a worldview that is not usually in synch with that of the “regular” investor. This particular article accepts that as a given, and starts from that point.

Heavy Bank Exposure to Derivatives Remains a Sizable Problem, Exacerbated by Still-Lousy Transparency

by Robert G. Yetman, Jr.

Banks are back at it. Actually, they never left the table.

The derivatives table, that is. It turns out that not only are banks still very much engaged in the same shenanigans that had such a big hand in creating the turmoil we often call the Great Recession of 2008, their exposure today…which, in turn, means your exposure today…to the inherent and substantial risks of derivatives is greater than it was when it seemed as though the global financial infrastructure was going to completely collapse eight years ago. Additionally, and collaterally, regulation and disclosure remain as ham-fisted as ever, so there is little chance you will know what is going on inside of your financial institution. While there are meaningful things that can be done to make the environment better for customers, investors, and even banks themselves, the necessary changes would have to occur at the level of banking DNA, so the likelihood of genuine improvement in the foreseeable future remains slim, at best.

A Reader’s Digest-Style Review of 2008

Before we talk about the present threat, it’s probably a good idea to review, compactly, what actually happened in 2008. A lot of factors conspired to bring the economy to its knees, but let’s keep things (relatively) simple, in the interest of expediency.

Broadly, it was what has been termed the housing crisis that led the way down, and the housing crisis unfolded in two, sequential steps, moving in quick succession. The first step came about when a lot of folks who had mortgages that outsized their ability to pay…all reached the point of failure at roughly the same time. The second step, which turned something bad into something catastrophic, was that the derivative securities that had been created on the backs of these mortgage loans, and that had come to represent an enormous portion of many banks’ portfolios, went under as a result of the underlying loans becoming non-performing, thus putting the entire financial system on the precipice.

Of course, up until things went so very bad, all was quite well. Everyone I know seemed to be getting on nicely, and one of America’s most foundational financial structures, the housing market, looked especially good. Because 100% mortgage loans were available to people with credit scores as low as 580 at that time, it meant that basically everyone could be a homeowner…except, they weren’t really homeowners. What was actually created in those days was not a new generation of homeowners in the way our parents and grandparents were homeowners, but, rather, just a new generation of hyper-extended borrowers, because, of course, you don’t actually own the house until you do so free and clear.

I mentioned the implosion of derivative securities as the centerpiece of the second step of the collapse. A derivative security is, at its most basic, an investment created from…or derived from…an underlying asset. In the case of the housing industry, then, and using nothing more than mortgage-backed securities as the example of a derivative, the actual mortgage loans (residential or commercial) represent the underlying asset, while the securities created from those pools of mortgage loans are the derivatives. Again, this is a greatly simplified explanation, but one that is accurate enough for our purposes here.

Moving on…

With respect to real estate, two “main” types of derivatives became particularly relevant to the 2008 collapse: mortgage-backed securities, including those commonly known as collateralized debt obligations (CDO’s), and something else, called a credit default swap.

To explain a credit default swap, let’s revisit the mortgage-backed security/CDO, for just a moment (I will use those terms somewhat interchangeably for the discussion at hand; they are not necessarily the same thing, but, again, treating them as though they are works for what we’re doing here). What makes the MBS a derivative that sort of…and I mean sort of…makes sense to most people, is that if you start with the MBS and begin peeling back the layers, eventually you end up at the underlying asset, the mortgage (to some, the real property to which the mortgage is attached is the “real” underlying asset of an MBS, but, either way, the point is that once you start digging down into a MBS/CDO to look at the guts, you eventually end up at the mortgage loans themselves, as well as the properties).

This is not the case for a credit default swap. It’s such a derivative of the underlying asset (mortgage loan or property, take your pick), that you might say it’s a derivative of a derivative. The credit default swap is basically an insurance contract, and is made available by insurance companies (of course) to investors…often hedge funds…that aren’t sold on the future greatness of the CDOs; if a collateralized debt obligation is wiped out, the credit default swap pays out.

So, this is, in very much of a nutshell, what happened in 2008: the banks, trying to make a bunch of money on the higher interest payments paid by CDO’s created from risky sub-prime mortgages (because the tradeoff with lower quality borrowers is that they pay higher interest rates, right?), owned a bunch of these derivatives in their portfolios, and when those failed, the failures, in turn, triggered massive claims by those entities that had purchased the credit default swaps against the insurance companies that issued them, companies like AIG – remember hearing about them every day on the news? The problem that the AIGs and Credit Suisses of the insurance world had in paying out the “claims” is that they had gone into this so confident that mortgage-backed securities were going to be just fine, that they didn’t bother to set aside any reserve capital in case things went bad (there were reasons for this confidence that went beyond simply cheery optimism, but, again, we’ll let that go for this discussion). We know what happened next.

It’s worth mentioning, too, that one of the principal, complicating…and, as it turned out, largely self-generated…factors in all of this for the financial institutions was the actions of the leading credit rating agencies…Moody’s, Standard & Poor’s, and Fitch…in giving their highest ratings (read: investment grade ratings)to mortgage-backed securities that were comprised of risky, sub-prime paper. As for why they did what they did, there are several reasons for it, not least which is the fact that the financial institutions that were paying for these ratings services needed to have the best ratings possible, regardless of the quality, and so applied pressure, both directly and by implication, on the agencies to produce.

Talk about “be careful what you ask for.”

The bottom line is that some of the biggest financial institutions in the world…banks, insurance companies, and those that are some of each…were either completely, or mostly, in ruins, and those that were still breathing were the recipients of your tax dollars, to a degree that is still practically unfathomable.

Let me jump to the not-so-funny punch line, one that I guess I gave away at the outset of this piece: Despite the ravages of 2008, not only are the biggest financial institutions in the world still knee-deep in derivatives, notwithstanding supposed financial reforms, their exposure is even greater than it was back when the Great Recession exploded. How’s that for ominous?

As for the actual amount of exposure, presently, let’s put some numbers to it. Estimates have the total dollar value of derivatives…called “notional” value…at the 25 largest U.S. banks to be around a staggering $247 trillion. By comparison, these banks have “only” around $14 trillion in assets. For your added consideration, let’s note that the current gross domestic product (GDP) of the United States is about $18 trillion. In other words, the derivatives at the largest financial institutions in the world dwarf…by a LOT…anything resembling real assets.

Adding to the worry is that the governments of the world…ours, theirs, everyone’s…are now so poorly capitalized after the last disaster that even if everyone was on board with a bailout the next time around, there is really no dough to throw at it. That raises the specter of a bail-in (talk about ominous), where banks don’t receive taxpayer money in order to survive, but must, instead, use their own assets…including your money on deposit…to get straight.

Bottom line: Banks and other financial institutions with a lot of derivative exposure create a bunch of risk, at a variety of levels, for you.

Lack of Transparency: The Derivatives-Heavy Bank’s Partner in Crime

One of the collateral problems is that after all of the supposed reform that was exerted on the financial services industry following 2008, there remains a stunning lack of genuine transparency, overall, that even more sophisticated investors clearly recognize. For investors, derivatives risk and insufficient transparency live in symbiosis.

One of the clues to the persistent transparency problem can be found in the current share prices of the world’s largest banks, as compared to the book values of these same institutions. A cursory review of the financials of every major financial institution you would recognize in name reveals that, in almost all cases, share prices remain well below book, which telegraphs both a lack of confidence in the assets, as stated, of these institutions, as well as in the likelihood they’ll be profitable anytime soon. While this article is written only several days following the historic Brexit vote, a historical review of price/book for some time now indicates the aforementioned lack of confidence in the sector.

A big part of the problem lies, ironically enough, in the slew of new regulations themselves, the same regulations designed to enhance the transparency that has proved so elusive. A crucial mistake made by regulators following the 2008 crisis was to slather on additional, complex rules that, ultimately, acted to both make things even harder for anyone to figure out (this includes sophisticated investors as well as Johnny Lunchbuckets) and create even more legalistic nooks and crannies into which banks can hide what’s really going on inside their portfolios. 2010’s Dodd-Frank was over 800 pages in length, and if you also take into account the numerous, new regulations that Dodd-Frank mandated, as well, you have a piece of legislation that, in totality, is really tens of thousands of pages long.

Seriously?

In the end, the problem of forthcoming-ness is so great that it exists at what is, essentially, a philosophical and cultural level; that is, it is about how the banking industry is perceived by those who work in it, by those who profit most fully from the way it is permitted to operate, presently. Accordingly, in order for there to be real change in terms of risk and transparency that benefits bank customers and investors, as well as the public, more generally, a culture change at the most organic level must take place – anything short of that will not yield the necessary improvements.

Fixing the Problem

The way to fix the problem, at least in terms of greater transparency (because massive derivatives exposure itself won’t be going away), is to cultivate, by hook or by crook, not just by better rules, but a better culture.

As for the “better rules” part, some over the years have been very vocal about presenting some awfully common-sense ideas. One great take on how to make things better came from a 2013 article in The Atlantic entitled, “What’s Inside America’s Banks?” Written by Frank Partnoy and Jesse Eisinger, the piece helps us understand how to get back on the right track by illustrating the differences between banking regulation and culture that came about just after the Great Depression, and regulation today.

Partnoy and Eisinger point out that the first, most important, step to be taken is that the entire paradigm of disclosure must be changed, and should go back to the relatively simple days that characterized how disclosures were made nearly a century ago. The authors point out that while banking infrastructure itself was also fraught with some convolution at that time…complex investment mechanisms existed even then, don’t you know…the manner in which investors were informed of what banks were doing was much more in keeping with plainspoken English. Additionally, the nature of the rules was oriented on commonsense standards. As Partnoy and Eisinger put it, “Commercial banks were not permitted to engage in investment-banking activity, and were required to set aside a reasonable amount of capital. Bankers were prohibited from taking outsize risks.” As matter of fact, say the authors, this was largely the lay of the regulatory land up until the 1980’s.

In other words, not only were disclosures more straightforward, but banking regulations were built on a foundation of what might be called a reasonable man standard. Banks could stray from the center, in terms of policies and foundational portfolios, but they could not motor along while remaining hanging off the side of a cliff, in the form of off-balance sheet accounting gone haywire.

The other step that must be taken, according to Partnoy and Eisinger, is that fear of real punishment must be returned to the banking community so that those inclined to roguish behavior may be appropriately disincentivized. As the authors point out…and it is a stark mention…coinciding with the massive multiplying of the rules ostensibly designed to banks and bankers on the straight and narrow, is the reality that no senior banker from any of the biggest houses went to prison in connection with anything stemming from the 2008 mess, and, beyond that, hardly any even had to pay fines.

This situation is vastly different from that which existed in the years following the 1929 crash, when plenty of high-level bank executives were sent off to the slammer for a variety of financial misdeeds. As Partnoy and Eisinger write, “The scrutiny and continuing threat of prosecution” during that time “convinced many bank executives that they should keep their business simple and transparent, or worry about the consequences if they did not.”

Regarding derivatives and variable interest entities (VIEs), in particular, the disclosure rules remain lousy for the investor. On that point, “way back” in 2010, Partnoy and Lynn Turner…who, among a plethora of credentials, served as Chief Accountant of the Securities and Exchange Commission…authored an article plainly-titled “Bring Transparency to Off-Balance Sheet Accounting” for the Roosevelt Institute’s Make Markets Be Markets report. In the piece, the authors outlined the following five principal recommendations aimed at improving derivative transparency:

  • Companies must include swaps on their balance sheets.
  • Companies must record all assets and liabilities of VIEs, in amounts based on the most likely outcome given current information.
  • Companies must report asset financings on the balance sheet (not as “sales”).                                      
  • Congress should adopt a legislative standard requiring such disclosures (mere “guidance” from the accounting industry is not enough).       
  • Companies that fail to disclose material facts should face civil liability.

Greater transparency, accompanied by more useful enforcement, is only a part of the solution. Ultimately, the only way that true, lasting change will be effected is through an improvement in the culture. As Steve Denning pointed out in a 2013 Forbes article entitled, “Big Banks and Derivatives: Why Another Financial Crisis Is Inevitable,” cracking down on the industry and requiring better, clearer disclosures will only really work if those components are “accompanied by a paradigm shift in the banking sector that changes the context in which banks operate and the way they are run, so that banks shift their goal from making money to adding value to stakeholders, particularly customers. This would require action from the legislature, the SEC, the stock market and the business schools, as well as of course the banks themselves.”

In other words, the core of the “fixes” is that we need banking elites to be better people, and while it would be great if the relevant parties could arrive at that point of their own accord, we probably just have to assume that the greed factor at that level is so powerful, so influential…just as the ability to wield real power so typically corrupts those who land in DC as elected officials…that they will need help achieving that morally and ethically improved state in the form of an acute effort at culture change that runs from business school to the highest levels of government. Until that happens, however, ignore the massive risk to financial institutions, and, in turn, to you, from derivatives at your own peril.

The Relationship Between the Price of Oil & the Value of Your Portfolio: A New Era…or Not So Much?

by Robert G. Yetman, Jr.

In the wake of a sharp upheaval in the price of oil and a more recent, uneven recovery (of sorts), an increasing number of so-called average investors are getting hip to the fact that the price action of black gold exerts a direct influence over the value of their IRAs, 401(k)s, even as those accounts may not contain any investments that are direct representatives of the energy industry. Typically, the stability or instability in a given sector of the economy is not something that affects an entire portfolio, but oil, as we’ve witnessed, is an exception to that sort-of rule. From a colloquial perspective, it might be said that this is due simply to the fact that oil remains, quite literally, the lifeblood of so many machines that drive productivity, but while there is a broad truth in that, there is, of course, much more to the story.

In general, the average person tends to think of significant drops in the price of oil as a good thing, and why not? After all, most of us think of oil exclusively in terms of the gasoline we put in our cars, and surely we want the price of that to be as low as possible, yes? Additionally, although domestic production continues to rise, the U.S. remains in a position where it is importing more oil than it is sending away, suggesting that lower prices should be better for us. This is a position taken by Dr. James Hamilton, an economics professor at the University of California at San Diego, who says that the “bottom line is that it’s a net plus for the U.S. economy when oil prices go down because we’re a net oil importer.” Is that, however, really the case?

The problem with that idea lies in its narrowness and simplicity, particularly in an increasingly globalized economy, where one country’s commodity sneeze means that another nation is about to come down with economic flu. The reality is that…going back to the original idea that oil is the fuel, quite literally, of everything, and, therefore, so much else is connected to it (more about that shortly)…significant troubles nowadays in the oil market can make for tough sledding in the economy, and, in turn, the equities markets, down to your portfolio. Let’s first briefly account for why the price of oil has been down, and then why those sharply lower prices have been exerting such a macro effect on economies and equities.

The Reasons for Oil’s Price Dump

There are basically four reasons for the now-enormous inventory of crude. For starters, a stronger dollar has acted directly in lowering the price of oil. Oil, like other commodities, is denominated in dollars, and so when the dollar is stronger, when it is worth more, it necessarily means that the corresponding store of value becomes worth less, but worth less not in and of itself, but, rather, relative to that dollar. In other words, oil does not magically become intrinsically less valuable because the dollar is now stronger, but becomes so because the unit of value in this case, the dollar, is worth more.

Another significant bit of causation in the downward slope in oil prices is the particularly weak demand for crude, globally. This is due to one primary factor, and another that is more secondary. The primary factor is that many nations around the globe are suffering from hyper-stagnant economies, and the malaise is afflicting both nations that are fully modern as well as those that are emerging and developing. The International Monetary Fund (IMF) has predicted that none of the G7 countries will see growth as high as even 3 percent in 2016, and Germany, France, Italy, Japan, and Canada, in particular, are expected to miss reaching even the 2 percent mark this year. As for upstart economic powers of recent years, neither Brazil nor Russia are expected to emerge from their recessionary conditions anytime soon, and growth forecasts for China, the world’s largest importer of oil, remain tepid.

Then there is the matter of OPEC and its approach to controlling oil production, presently. That body has shown itself to be unwilling to cut production and keep prices elevated, in spite of the beating taken by member nations like Nigeria and Venezuela. It is believed that Saudi Arabia, the 800-pound gorilla in the OPEC room (it is the world’s largest oil exporter), is seeking to keep the pressure on America’s energetic shale oil and gas industry. The aforementioned Nigeria and Venezuela are examples of OPEC countries that do not have the deep pockets capable of withstanding the strategic approach taken by Saudi Arabia to maintain high production levels, and their own economies are suffering, as a result. Nevertheless, the less well-heeled member nations of OPEC are in no position to leave, because they cannot, on their own, enjoy the higher prices and better times that will resume once OPEC decides to move past its present strategic efforts.

Additional factors include America’s own significant uptick in domestic oil production, referenced in the preceding paragraph, as well as the effects of the much-maligned Iran nuclear deal. By agreeing to a reduction of its nuclear facilities, one of the benefits to Iran was the immediate lifting of U.S. and European Union sanctions against the Iranian oil industry. Ultimately, more oil is flooding the market.

Effects of the Price Drop

The precipitous drop in oil prices has resulted in wide-ranging economic fallout, and it is this fallout that serves as the bridge from the core reasons for oil’s price decline to its deleterious effects on the equities markets (and your portfolio).

For starters, the price drop has had its most direct and pronounced effect on the stability of those companies whose business is oil. To drill down at this (if you’ll pardon the pun) more specifically, oil operations can be broadly divided into two categories, upstream and downstream. Upstream operations refer to those activities that occur earlier on in the process of bringing oil to market, like exploration and production. Downstream operations are those that take place later on in the overall process, and have to do with refining and distribution. Because the costs of upstream operations are fixed, and generally more expensive because of the advanced drilling technologies utilized, companies that are oriented in the upstream part of the process have been hit hardest by the price drop; as with anything, once the cost of producing a good becomes greater than the price that can be received, losses ensue. Downstream operators don’t have as big a problem; as their role in the process is more of a middleman, in that they buy crude on one end and sell the refined on the other, fluctuations in the price of oil, per se, don’t necessarily affect their profit margins.

The end result is that those companies that are all upstream operations have been hit the hardest. However, as the largest oil companies are “integrated,” meaning that they participate in both upstream and downstream operations, their fortunes tumbled sharply, as well, when oil prices drop precipitously.   

Additionally, of course, is the matter of layoffs. As oil companies fight to gain a handle on costs, job cuts remain a core tool of the effort. Over 23,000 workers were laid off in the first three months of this year, and a total of nearly 118,000 industry jobs have been lost since the beginning of 2015. Sharp layoffs mean trouble for local economies built around specific industries in distress, including in the form of homes foreclosures. Foreclosures in Texas jumped about 16 percent last year, while in Oklahoma they went up 36 percent. In North Dakota, filings in 2015 represented a near 400 percent increase.

There’s more to this part of it, and it shows how infectious these problems can be for other sectors, like banking and financial services. Oil companies engaged in upstream operations borrowed heavily to pay for the pricey drilling operations – that made particular sense at $100 a barrel, but the backslide in prices that began in the middle of 2014 largely changed all of that. In Q1 2016, nearly 90 percent of the operating profits derived from the energy sector were applied to just the interest payments on outstanding debt. All of the biggest banks have seen a recent jump in the number of non-performing loans in the energy sector, and, earlier this year, JPMorgan Chase declared it might have to set aside as much as $750 million in reserves this year, depending on how oil continues to move; during Q1, it increased reserves by $529 million, and while total loan loss reserves there are well over $1 billion, presently, it is unclear how effectively this sum can offset the potential troubles looming from energy-related loans overall. Both JPMorgan Chase and Wells Fargo presently have well over $40 billion in energy-related loans on its books. While it does appear that the largest banks have been very proactive in beating back the worst of the potential damage threatened by trouble in the energy sector, uncertainty over how things proceed from here remains. Relatedly, Standard & Poor’s warned at the beginning of 2016 that half of all oil junk bonds could default. 

Also, while I noted weak global growth as a key reason for the drop in oil prices…and particularly throughout much of the emerging market…it is also, simultaneously, an effect of the price drop, as well. The economies of Brazil and Russia, for example, rely largely on energy exports.

Adding insult to injury is that it does not appear, on the consumer side, as though savings on energy products are translating into any benefit to the economy, at large. Gross domestic product (GDP) has been declining steadily in recent quarters, according to the Commerce Department: 2.0 percent growth in GDP in Q3 2015 was followed by 1.4 percent growth in Q4 2015, and just 0.5 percent growth in Q1 2016. Granted, there’s a lot more to this than just whatever singular benefit might be realized from a savings at the pump, and that is, really the point; the economic problems remain so vast, and the far-reaching effects of oil’s troubles so substantial, that they far outsize and potential benefit offered to the economy on the consumer side of the equation. Retail sales, specifically, remain sluggish.   

 The Link Between Oil Prices and the Equities Markets

Many analysts have marveled at the recent and historically-significant (they say) correlation between the movement in oil prices and broad equities market activities, but I remain unclear at what, precisely, makes this so momentous or noteworthy.

Analysts will tell you that the relationship between oil and stocks has been basically unprecedented, and many have gone to great lengths to explain the “unusual” relationship. However, in a piece published earlier this year at the Brookings Institution’s website, Ben Bernanke, the former Chairman of the Federal Reserve, articulates how what we are seeing is not as unusual as it might first appear to many. Using a sample that goes back roughly five years, to mid-2011, Bernanke illustrates the overall positive correlation between stocks and oil prices during that time; as he puts it, “The tendency of stocks and oil prices to move together is not a new development; it goes back nearly five years (the limits of our sample) and probably more.”

In the analysis published by Bernanke, he shows a positive correlation between stock prices, as represented by the S&P 500, and oil, as represented by the WTI crude price, of .39, as well as an even stronger positive correlation between stock prices and the demand component of oil, of .48.

In other words, while the volatility of the last year or so has evidenced a particularly noteworthy correlation between stock and oil prices, it is not accurate to suggest that a positive correlation has not existed previously. Bernanke speculates that the reason the relationship has been more pronounced lately is because, in a nutshell, sharply negative conditions in the oil market will tend to exacerbate the already-existing relationship.

We have seen signs lately that there has been a “decoupling” of oil prices from stock prices, but it is important to point out that this decoupling has come on the back of some stabilization in the price of oil, something Bernanke would find unsurprising. He would disagree, however, that we are seeing a true decoupling, but simply a lower correlative relationship – for much of 2016, the correlation between oil and stock prices has been close to 1.  

The fact that energy is less than 3 percent of the U.S. economy, which is something to which many point when they express out loud their curiosity over the recent relationship between oil and stocks, is deceiving, for reasons we have discussed earlier; that is, while energy may be a small component of the overall economy in the most direct sense, its impact, particularly in climates of significantly negative price action, is substantial.

In other words, oil prices and stock prices are, generally, positively correlated, and become increasingly so the more the price of oil declines. No real shock there, given the factors.

So, what does this mean for you, as an equities investor?

Not as much as you might think, if your perspective is longer-term. Remember that we’re having this discussion entirely in the context of oil prices as an influencer of general stock market activity. Abnormally low oil prices are not sustainable for any appreciable length of time, which is what makes them abnormal. The strategic efforts by OPEC to pursue America’s markedly increased production by operating at its own high levels, in spite of the price volatility that ensues and the particular damage it is doing to the economies of its smallest member nations, cannot be engaged entirely in an infinite time and space vacuum, despite the significant reserves of the largest OPEC countries. Even if OPEC does remain intractable in its position for the foreseeable future, the determined efforts on the part of U.S. companies to lower the costs associated with shale production are now in the process of reaching a sort of critical mass, where the per-barrel breakeven point for oil well profitability has dropped below $50 at many sites. In other words, in the OPEC-U.S. oil duel, the U.S. is winning.

Let’s talk about the last part of the previous paragraph a little more, because it appears to contradict what was said earlier about the importance of higher-cost oil economically validating the expenses associated with drilling. As events unfold in real time, the high-cost technologies that are designed to ultimately improve efficiency are beginning to bear financial fruit. For example, as “super fracking,” a drilling technology designed to penetrate the rock formations more deeply, improves well production, breakeven costs drop. The U.S, has assumed the lead in so-called unconventional drilling techniques, while Saudi Arabia remains largely tied to more conventional…and higher cost…methods of oil extraction.  

While oil (WTI, Cushing, OK) went from just over $105 per barrel in June 2014 (average daily price for the month) to 30.32 (average daily price) this past February, it has risen from there to 49.10 as of today. No one expects oil to move directly back to $100-plus per barrel, but neither is it expected to go crashing to the floor. Additionally, as U.S. production…at lower breakeven points…continues to increase, the influence of price, per se, on oil companies directly will be lessened.

So oil is in the midst of a recovery, of sorts, and as it makes its way back, the direct effect it exerts on market activity becomes less intense. Yes, the two are more closely correlated the further south oil prices travel, but acutely lower prices are not sustainable over the long term, and that is, really, the overriding point as you ponder just what sort of weight to attribute to oil, vis-à-vis your long-term investing outlook. The biggest issue in the near term is the trend in inventory, but as a shorter-term issue, it would be unwise to allow oneself to become too caught up in that from the standpoint of strategic equity investing. From a more active, more tactical standpoint, there are, even now, oil-centric moves to make, but that is a story for another time.

The War Against Terror Finance, Through the Lens of Islamic State Oil

by Robert G. Yetman, Jr.

Modern terrorism is, like practically everything else in the world, a slave to money. While most of us tend to instinctively think of terrorism in terms of the fear it inspires and the devastation it causes, the physical toll it takes would not be achievable without the supply of money that serves as its lifeline. The study and analysis of terror finance, while no longer in its infancy, is still relatively new to many governments around the world, which is partly why it is taking so long to gain anything even approaching a handle on it. Given this, while it is important to look at the more acute ways the underlying structure of specific terror finance mechanisms can be torn asunder, it is also important to consider terror finance in the larger context in which it flourishes…namely, the failing/failed state reality that continues to consume greater portions of the globe. While the success realized by the Islamic State in turning black gold into black market cash is due in no small way to its clear mastery at developing an impressive underground oil network, it is important to remain mindful of the role played by the growing number of at-risk states in providing fertile ground for the takeover of their various natural resources by terror groups, including the Islamic State. 

The White House recently crowed about the efforts of the United States and its regional partners to strike at…literally…the various supply channels for black market oil in the Middle East, oil that has, in the belief of analysts, come to represent the source of roughly one-half of the money used by the Islamic State (IS) to operate in the region. The latest, most dedicated (apparently) effort has come in the form of Operation Tidal Wave II, which began last fall and is a refocusing of previous, “like” efforts on IS operations in Syria, this time around specifically targeting assets that cannot be replaced or repaired quickly by the terror group. According to recent comments by White House spokesman Josh Earnest, the effort has dealt a “significant setback” to Islamic State operations in the region, and his boss, addressing the Central Intelligence Agency at the same time, similarly said that the airstrikes have “reduced their oil production and their oil revenue.” What these comments mean, exactly, in terms of the impact to IS oil operations is, at present, unclear – this particular subject will be addressed more directly later in this piece. 

The penetration of oil’s black market is but one of many sources of terror financing, but it has become significant in Islamic State’s efforts over recent years. For those new to the topic, there are essentially four main source categories of money for terror: state sponsorship, popular support, legal activities, and illegal activities, with the capture and monetization of a country’s natural resources by a non-state group representing, perhaps, the most lucrative form of its illegal ones. 

The Symbiosis of State Fragility and the Good Health of Islamic State Oil Operations

As might be expected, the ability of a terror group to exploit select natural resources for its own benefit is generally correlated with the degree of nation-state stability in the region(s) in which it operates. That is, the stronger the governance in an area, to include rigid oversight of its natural resources, the more limited, generally, the ability of a terror group to commandeer said natural resources for its own benefit. In cases where governance is weak, there is profoundly greater opportunity for terror groups to thrive on the back of natural resources, and that has proven to be the case with Islamic State and oil, wherein it has managed to maintain highly-lucrative oil operations in Syria and Iraq. Serving as the backdrop to the obvious military violence and upheaval observers know all too well is the definable, overall instability of each country – Syria and Iraq are presently ranked nos. 8 and 12, respectively, on the list of world’s most fragile states compiled by the Fragile States Index. It is difficult for people who have known only stable governance throughout their lifetimes, particularly that characteristic of Western-style democracy, to appreciate the degree to which a “badlands” type of human environment persists in those parts of the world where an adherence to a high-functioning form of government rooted in the Westphalian ideal simply does not exist.

A report by the Financial Action Task Force (FATF), “Emerging Terrorist Financing Risks,” dated October 2015, further clarifies the range of natural resources at risk of cooption by terror groups, one that includes (besides oil) gas, timber, precious metals, charcoal, and even wildlife, in the form of activities like ivory trading. The same report points out that in addition to the revenue derived by a terror group from the control of a given natural resource, the group necessarily comes to enjoy control over the geographical territory in which the resource is located, as well. This is sometimes an element of natural resource-based terror finance that is not always considered, and one that sets it apart from the other kinds of activities engaged for the purpose of generating revenue.

It is, flatly, the marginal existences of the nation-states from which the Islamic State has sought to develop an operational platform that affords the group the opportunity to initially assert enough influence over the territories in which the oil and oil assets are located…influence that, shortly thereafter, permits it to reach “tipping points” in those locations that result in the control they seek.

Islamic State Oil

Islamic State’s aggressive efforts to capture oil resources and assets began in earnest in 2014, and the first, real blush of success came with the takeover of several producing oilfields in Northern Iraq. Additionally, according to a December 6, 2015 Los Angeles Times article, in 2014 the Islamic State “secured” Dair Alzour, an eastern province of Syria, a victory that has reportedly resulted in the terror group controlling about two-thirds of the entire oil production capacity of that country.

While oil production from Islamic State-controlled oilfields is about 10% of what it was when the nations in which it is operating were (relatively) functional, what they do generate represents a massive, regular benefit to the group. Estimates of just how much money IS sees from its oil operations can vary widely, but there is general agreement on a figure of about $1 million per day, presently. Now that the White House is claiming that substantial inroads have recently been made in knocking out the terror group’s oil assets, it will be important to learn if that number evidences signs of significant deterioration from this point forward. As will be noted in just a bit, some key data available up through just a few months ago suggests no such noticeable effect has yet been achieved.

It is important to underline just how unique a resource like oil is in terms of its value to a terror group. For example, the noted Los Angeles Times article mentions that a sizable portion of the oil cultivated by the Islamic State remains inside of Syria for use within regions of the country under the group’s control, a declaration substantiated by the FATF’s Emerging Terrorist Financing Risks Report, which points out that “ISIL benefits mostly from using the petroleum and petroleum products it controls or by earning revenue from sales of these resources to local customers.” Again, this is a feature of oil and gas products that distinguishes them from, really, every other natural resource hijacked by a terror group.

As for where the oil does end up when it is sent off beyond the borders of Iraq and Syria…Iran, Turkey, and Jordan are generally considered to be the primary beneficial recipients of the smuggling activities. It is, in fact, the allegedly very-willing participation of Turkey as a recipient of Islamic State-controlled oil that is partly responsible for putting the success of IS oil efforts on steroids. While analysts have, for some time, thought Turkey to be an active participant in the oil exchange with the Islamic State, Russia has gone as far as to directly and boldly accuse Turkey and Turkish president, Recep Tayyip Erdogan, personally, of knowingly consuming IS-controlled oil from Iraq and Syria. An aggressive round of charges to that effect came from among the highest levels of Russian military leadership back at the beginning of December 2015, with Anatoly Antonov, a Russian deputy defense minister, saying:

“Turkey is the main consumer of the oil stolen from its rightful owners, Syria and Iraq. According to information we’ve received, the senior political leadership of the country – President Erdogan and his family – are involved in this criminal business. In the West, no one has asked questions about the fact that the Turkish president’s son heads one of the biggest energy companies, or that his son has been appointed energy minister. What a marvelous family business!”

Although Erdogan very publicly responded that he would resign if the allegations could be proven true, the noted Los Angeles Times article reported that many observers simply do not feel it is possible for the oil smuggling activity known to take place into Turkey from the Islamic State to exist at the significant level it apparently does without the sanction of the government. The article quoted Salman Khalaf, head of a Syrian energy commission, who said flatly, “The only borders open with Daesh (Islamic State) are the ones with Turkey,” and also quoted former Iraqi national security advisor Mowaffak Rubaie, who said, “No insurgent group, whether it’s the Islamic State or not, can survive without a neighboring country either directly supporting it or turning a blind eye to it. The Turks have to come clean and be on the side of counter-terrorism in the region, full stop.” For his part, and quoted in the same article, Iraqi Oil Ministry spokesman Asim Jihad simply asked, rhetorically, “How do tens of trucks with Iraqi and Syrian oil leave the area? Where is this oil going? Who is dealing with it?” Wherever it is going, someone is clearly buying it, and on a large enough scale that it is not plausible to believe that the transactions are happening without the sanction, at some level, of the states to which the oil is traveling.

In light of the most recent White House pronouncements, however, the issue is raised as to whether the Islamic State and its collaborators enjoying the fruits of freewheeling days in the outlaw oil business may be nearing an end. There is evidence that the fortunes of the Islamic State’s relatively unchecked oil operations began to take a substantial shift with the neutralization by U.S. Special Forces of IS’s number one in its oil operations, Aby Sayyaf (real name: Fathi ben Awn ben Jildi Murad al-Tunisi), in May 2015. While the death of Abu Sayyaf, along with the capture of intelligence resources during the raid, represented, perhaps, the first, real, useful step in the singular war against Islamic State’s foothold in oil, there is much to be done before a point is reached where oil revenues can be said to make up no more than a sliver of the IS revenue pie. 

The Wall Street Journal, in an article dated April 24, 2016, says that the complex network of oil operatives, at all levels, that Sayyaf built and maintained was responsible for about 72% of the $289.5 million in total revenue generated from natural resources controlled by the Islamic State during the six-month period that ended late February 2015. These numbers translate to daily revenues that averaged more than $1.1 million for that period. While Defense Secretary Ash Carter hailed the raid that killed Sayyaf last May as a “significant blow” to the fortunes of the Islamic State, it remains to be seen if the stepped-up military efforts against IS oil assets…again, many of which have been facilitated by the intelligence uncovered during that raid…will materially diminish IS oil operations. The Wall Street Journal article indicates that in the 11 months since the raid that killed Sayyaf, roughly 30% of the IS’s “oil infrastructure” has been wiped out, according to U.S. officials, and that taxation…another standard money-maker for terror organizations…has replaced oil as the group’s biggest revenue generator. Nevertheless, with estimates that the Islamic State’s oil operations are still generating around $1 million per day, it is difficult to reconcile that number with White House shouting about the effectiveness of more recent, and more surgical, strikes against Islamic State oil assets.

The Way Forward

The FATF’s Emerging Terrorist Financing Risks report broadly details the array of efforts that can be applied to curtail the commandeering of natural resources by terror groups. In particular, the report notes that the detailed and carefully managed smuggling networks that extend beyond the national boundaries, such as they exist, of the countries in which the terror groups lord over natural resources…can really be suppressed only through effective collaboration among a variety of entities in both the public and private sectors, including some that fall outside of the traditional anti-money laundering and counter-terrorist financing regime.  The report also makes explicit mention of the importance of enhancing, overall, “legislative and regulatory frameworks;” more about the inherent challenge of legal remedies in just a bit.

In his journal article “The Sources of Terrorist Financing: Theory and Typology,” Michael Freeman addresses the importance of applying a holistic approach to countering terrorist finance, pointing out that not only will no one strategy have universal applicability to defeating the variety of terror funding strategies in use, but that, additionally, strategies will have to be altered to address the differences among the inherent natures of the groups themselves. He goes on in his article to make the excellent point that while states are now much better equipped to track and suppress the movement of money derived from terror group efforts, they still struggle with securing the sources of the cash, and a big reason for that lies with the scarcity of resources available to actually secure those sources, with all that involves. Ultimately, says Freeman (quite succinctly), states must create an environment wherein the efforts at acquiring funds, for a terror group, must be made “illegitimate, dangerous, unreliable, distracting, and complicated.”

The most relevant (to the singular issue of exploitation of natural resources)of Freeman’s suggestions to the issue of slowing the flow of oil from Islamic State-controlled regions out of Iraq and Syria to neighboring countries allegedly complicit in receiving the product…is to bring international pressure to bear on the guilty nations. Such an effort, in addition to a dogged adherence to an ongoing regimen of air strikes and other military attacks against IS oil assets, is perhaps the best available method by which to significantly reduce the amount of money earned by the Islamic State. This said, Freeman acknowledges that such measures can often yield a poor result in seeking to stop other nations from supporting terrorism…in this case, by buying terrorist oil. This is a particularly relevant problem when the “smoking gun” level of proof of complicity on the part of alleged state-level black market oil recipients, like Turkey, continues to elude the U.S. and its allies.

Like the FATF’s Emerging Terrorist Financing Risks report, Freeman suggests the option of pursuing legal redress, as well, in dealing with terror finance. Again, though, while that can work more readily in state environments that remain reasonably functional, but not as much in more problematic ones. As for the issue at hand, the level of instability of the regimes in which the Islamic State operates the refineries it now possesses…suggests that there is little that the rule of law can accomplish, when the rule of law is itself largely MIA.

In the case of hugely unstable countries like Iraq and Syria, it is difficult to implement legal remedies in the way such might be implemented in more stable regimes, and so what remains, as far as readily-accessible tactics, are the more drastic measures that countries like the U.S. are forced to take in dealing with the commandeering of natural resources by non-state groups. This, then, brings the discussion back to the matter of military attacks against Islamic State oil assets, first and foremost. All told, the U.S. appears to be doing the right thing, and the best thing, under the circumstances and with what options are realistically available to it. 

Unfortunately, the effort, singularly, will prove to be insufficient in curbing the overall trend of terror finance. The money, and mechanisms by which it is raised, will remain functions of the fertile territory provided by failing and failed state environments. As perilous as failing states, in general, are to world security in what has become, sadly an era of social, indeed human, devolution, those failing states rich in natural resources pose even greater threats, for clearly evident reasons. Ultimately, then, it is only by the comprehensive, holistic approach…both suggested by Freeman and others in terms of terror finance, specifically, and by others in terms of transnational insurgency, more generally… that the metastatic dangers posed by failing regimes…which lead, in turn, to failing regions…may be kept in check; and like cancer of the body, it may well be that the relentlessness of this disease demands a new outlook…one that finds “victory” in the form of containment, even management, rather than outright threat eradication. While many remain unnerved by the thought of embracing genuine and chronic threat management as a best-case global security paradigm, it increasingly appears to be the most positive scenario that can be realistically achieved in the era of the failing state.

Collapsing Exchange-Traded Note Investment is Basis for Arbitration Claim Against Morgan Stanley

by Robert G. Yetman, Jr.

A recent arbitration claim filed against Morgan Stanley by an elderly North Carolina couple once again highlights the dangers…to all involved…associated with a firm green-lighting unsophisticated customer investments that are characterized by lopsided portfolio weightings into a complex and risky securities.

According to a piece over at Investment News by Christine Idzelis, now working at IN after spending years cranking out great stuff on credit markets over at Bloomberg News, the unidentified couple is pursuing Morgan Stanley over losses in excess of $100,000 that resulted when the exchange-traded note, or ETN, into which about $150,000 of their total $212,000 portfolio was invested, came crashing down around them. The note is essentially a collateral product of the energy industry, and tracks an index of master limited partnerships that largely own oil and gas transportation and storage assets. To make matters worse, the ETN is a proprietary Morgan Stanley product, which is the sort of fact with which lawyers usually have a field day in cases like this.

What are Exchange-Traded Notes, Anyway?

ETNs fairly fall into the category of “clever” securities. They were devised with the idea of combining, ideally, the best features of bonds and exchange-traded funds (ETFs). ETNs are technically debt securities, but the market feature means they can be traded, sold short, etc. They are unsecured debt obligations issued with the backing of the relevant financial institution (Morgan Stanley, in this case), which means that while a promise to pay exists, there is no guarantee of payment. A key element of ETNs is that the credit rating of the issuer is a function of their stability, so credit risk is a constant companion of the ETN investor, even as the instrument is “exchange-traded.” It should be noted, however, that credit risk did not prove to be the source of the plaintiffs’ problems with the ETN in this case, but, rather, the deterioration of the market with which the security is intrinsically associated (more about that shortly).

The ETN investor can potentially profit in one of two ways: One way is that he can elect to treat the investment as more bond than stock, and hold it to maturity, at which point he receives back his principal investment plus the gain represented by the commodity or asset to which the note is tied. For example, an investor who puts $5,000 in an ETN associated with an index or single reference asset that sees that index/asset go up 10% while he holds it to term would receive $5500 at maturity.

The other way the investor can potentially profit is by deciding, alternatively, to treat the ETN as more stock than bond, and sell it as the exchange-based security it also is, sometime before the maturity date; for example, if the person who invested $5,000 gets two months in and sees that the value of the associated index/asset has appreciated 15% in that brief period, and wants to lock in his profits, he can sell, and pocket $750 on top of his $5,000 principal investment.

Of course, the index or asset can go down, as well, which is what happened here. If such is the case when the note reaches maturity or is sold, the principal investment is reduced by the amount of the index/asset’s loss.

It is worth emphasizing that interest does not accrue on behalf of an ETN, nor is there any guarantee associated with the security – it pays principal, plus or minus what the gain/loss is in the associated index or asset when you cash out (whether at maturity or beforehand).

Troubling Components to This Case

Although there appear to be several issues at play here, surely one of the biggest is that roughly 70 percent of the customers’ total account value was invested not just in one type of more complex kind of security (that can be fraught with liquidity issues), but, further, in one, specific issue of that security; even as relatively harmless as we all typically view broad-based mutual funds, who among us would think apportioning almost three-quarters of a $200,000-plus portfolio into one of those is an example of sound investment thinking?

Some might wonder why liquidity is so much of a concern with ETNs; after all, are they not exchange-traded?  The answer is that while, yes, they are…the fact is that “exchange-traded” can be a little deceiving in the case of more exotic securities. Many such securities, ETNs included, are thinly-traded, so while the transactional exchange exists, it does not mean that a genuine market, for all intents and purposes, develops.

An additional problem here has to do with the likely level of investor sophistication that characterizes this couple. It is said that one should not invest in a security that he does not understand, and it would be surprising to me if the plaintiffs…neither of whom appear, based on the rough profiles contained in the article, to be sophisticated investors…even remotely understood what the Morgan Stanley Cushing MLP High Income Index ETN was all about.

The particular ETN at issue here tracks the performance of the Cushing MLP High Income Index, which itself tracks the performance of 30 master limited partnerships that hold assets related to the energy industry (note that master limited partnerships, unlike their “regular” counterparts, are traded on an exchange). For example, two of the index’s constituents, at this writing, are Plains All American Pipeline, LP, and Enbridge Energy Partners, LP. Plains owns terminal, storage, and pipeline assets, and Enbridge also owns assets related to the transportation of oil and natural gas. Theoretically, investments built around the ownership of these kinds of assets are havens within the energy sector, which means that even as things are going south with the commodity itself, an investor might find some relief here, because the energy industry would still need operational infrastructure even as prices tank. That however, seems a largely self-serving assessment; it is awfully risky business to suggest that a commodity-associated industry will reliably thrive, or even manage to tread water, in the face of a price collapse of the commodity to which it is directly and entirely tied.

Moreover, did the investors really understand how the ETN mechanism works, particularly vis-à-vis the index to which it is married? Did they really understand that the security represented ownership of nothing (unlike an ETF), and that the best they were getting was an unguaranteed promise to pay?

To be fair, we can assume that the Investment News article, as is the case with most articles on new and pending arbitration and litigation, does not provide the full context and details pertaining to this situation, largely because such information does not typically come available this early in a proceeding. Moreover, anyone who has spent much time on the registered side of the investment business will tell you that there are those clients to whom you introduce a product and provide all of the relevant disclosure materials, who will then insist that you take a bunch of their cash and dump it in the security, simultaneously choosing to compartmentalize the array of risks inherent with the security type, market, and elected lack of diversification. Still, though, this is where the broker has to stick to his guns and, if that somehow fails, where the firm’s back office can make things right. On that note, I have to wonder where Morgan Stanley’s back office was in all of this. Did a branch manager approve this trade? What about the compliance officer(s)?       

According to the Investment News article, the law firm representing the plaintiffs has said that the couple “did not understand the extent that they could lose their principal.” We do not know, at this point, how true that is, but the basic information we have about this transaction…the nature of the security, the portfolio percentage allocated into it, the profile of the customers…seems to strengthen the credibility of such a declaration. Beyond that, if it turns out that Morgan Stanley had discretionary trading authority over the account, something typically granted by clients to firms through a limited power of attorney, then it may well turn out that the trade was made on behalf of the customers without consultation or foreknowledge; if that is true, then it would most certainly prove to be a case that Morgan Stanley loses, given the choice of security as well as the percentage of the account invested into it. Still, even if that is not how this trade went down, the bottom line is that if 70% of an elderly customers’ account really went into a risky, complex, proprietary security, and no red flag went up anywhere before the investment lost over 65% of its principal value, that’s a bad look for the brokerage, regardless of from what angle you’re examining the picture.

Is a Near-Zero Percent Savings Rate EVER the Responsibility of People Themselves?

by Robert G. Yetman, Jr.

A recent piece at Boston.com reported on some analysis done by the Economic Policy Institute that reveals most U.S. citizens are woefully ill-prepared for retirement. The EPI found that the average American family has only $5,000 set aside in a nest-egg, and, further, that this poor savings rate cuts across all generations; the median number of dollars in retirement savings accumulated by heads of household between ages 55 and 61 is an ominously-low $17,000.

Those of us who write about money have long been aware of the lousy savings rates of Americans for years now, and so while this latest round of figures is disappointing, it certainly does not come as an earth-shattering surprise.

What I did find to be particularly striking, however, was Boston.com’s not-so-veiled commentary about the situation. Here is what the article, entitled, “Analysis of 401(k)s and IRAs shows American families are in dangerous financial territory,” says, in part:

“As The Boston Globe points out, there are many reasons American families aren’t saving for retirement, including stagnant wages and businesses neglecting to offer workers 401(k)s.

If you’re a young working person looking to avoid the fate of so many Americans, there are plenty of ways to start adequately preparing for retirement, even if your employer doesn’t offer a 401(k), or you live in an expensive city like Boston.

To begin, think about meeting with a financial planner, starting an emergency savings fund, and squirreling away at least 10 percent of your annual salary for retirement. Oh, and lay off the booze and coffee.

For families without savings accounts who are rapidly approaching retirement age, the Globe writes that Social Security provides ‘a vital lifeline’ that Democrats like Hillary Clinton and Bernie Sanders want to expand.”

One need not be an expert at reading between lines to discern Boston.com agenda, as well as its associated disingenuousness; right after the article identifies “stagnant wages” and “businesses neglecting to offer workers 401(k)s” as primary reasons for why so few have saved anything for retirement…in other words, it is the evil system that conspires to hold us all down…it readily admits in the paragraphs that follow that “there are plenty of ways to prepare for retirement,” and that even relatively minor lifestyle changes can give many folks the money they need to set aside each month in order to have a meaningful nest-egg at retirement.

The simple reality is that if you open an IRA as (relatively) late as age 40 in broad-based equity mutual funds, max it out each year…including to the higher limits granted those over 50…and, assuming an annual rate of return of just 6.5% per year (the historical, inflation-adjusted, annual return of the S&P 500 is about 7%), you’ll have about $550,000 by age 70; do you not love the immutable truth of mathematics? Even if you just do half of what you’re allowed each year in an IRA, beginning at 40 and assuming 6.5% per year, you’ll still have about $270,000 by age 70 – not an enormous sum, but not insignificant, either, and a damn sight more than zero.

Why, however, talk about the roles of personal initiative and accountability in all of this? That’s no fun, and it will make those who are disinterested in taking responsibility for their own retirement feel bad. Instead, let those who are inclined to remain financially irresponsible do just that, which, in turn, helps to grow the entitlement class that will ultimately guarantee the elections of pandering politicians, until there is no money left for THEM to steal from those who actually see fit to prepare…at which point it will all come crashing down; that’s a MUCH better plan.

Reverse Churning Prioritization by SEC is Another Example of Regulatory Overreach

by Robert G. Yetman, Jr.

The Securities and Exchange Commission recently announced that “reverse churning” is among its Office of Compliance Inspections and Examinations’ (OCIE) priorities for 2016. Are you familiar with reverse churning?

You likely know about churning, which is the practice of executing trades in a securities account primarily for the purpose of generating sales commissions. As the definition implies, it is the province of commission-based compensation structures, rather than those that are fee-only in makeup (fee-based financial advisors can, potentially, engage in churning, as well). A managed account from which the advisor is compensated solely by a percentage-based fee assessed against assets under management does not, obviously, present a nefarious broker with an opportunity to churn…but some would say that reverse churning is the shoddy, fee-only adviser’s answer to that. That said, I see the “problem” of “reverse churning” as, largely, a regulatory contrivance designed to serve as an entrée for even more regulation and more fines…and simply another effort by regulators to become even more bloated at the expense of industry professionals.

With so-called reverse churning, the sin lies in the adviser’s lack of activity on behalf of the investment account, which is, obviously, the opposite of how churning works…but is typically relevant only to managed accounts wherein the sole compensation to the adviser comes in the form of a fee assessed against assets under management, and transaction-based commissions are not available. For example, let’s say you have $250,000 under management at XYZ Advisers, and you pay a 1% percent management fee annually, against assets under management, for the service. Let’s further say, for the sake of discussion, that the 1% is charged in the form of a fee of 25 basis points debited against total account value at the beginning of each quarter. Again, to keep things simple, let’s further declare that your account is at $250,000 when .25% is debited at the outset of a three-month period. You have just paid your adviser $625 for his services on behalf of your account for the quarter. The quarter comes and goes, and it turns out that your account was traded infrequently, or maybe not at all. The SEC might well say you might have an adviser guilty of reverse churning, because he collected your $625, but then made few, if any, trades during the covered period.

I’m not suggesting that an adviser who genuinely sits on your account and does nothing to justify his fee over an extended period (you pick the period…one quarter, six months, a year) is not a problem, but what I am saying is that it is generally a customer service problem, and not one that rises to the level of being a regulatory issue. Assuming a customer is receiving account statements no less than quarterly, and transactions statements as trades are being executed, then he is going to know whether his account is being traded, as well as if it is making money (and, more specifically, reflecting a positive alpha coefficient return, which means, in layman’s terms, outperforming the market index of which it is representative). If he has questions, he can pick up the phone and speak to his representative. If he likes the explanation, great; if not, he can fire his advisor and move on to someone else, or even take over management himself.

If you pay your lawn maintenance guy a flat fee each month to service your yard and you don’t see him as often as you should, what do you do? Your fire him; you don’t call the state attorney general’s office.

An important, related issue is the matter of whether the account is making money (or not losing as much in a down market – again, positive alpha) in spite of a dearth of active trading. The fact is that not trading an account is every bit as viable a management tactic as trading it, depending on a wide array of factors that include client-elected management style, market climate, and economic climate…the very same set of criteria that are used to determine when and how it should be traded into securities. Sometimes the smartest thing to do is sit tight. This can be particularly important in “regular” brokerage accounts that do not enjoy any kind of tax-preferred status, wherein trades can often result in adverse tax consequences for account owners.

An important caveat to the above is that an adviser must be able to clearly articulate why less activity, or even no activity, was the best approach to take with an account over an appropriately-considered interval. Nor will I say that there is no circumstance where an alleged case of reverse churning doesn’t warrant a look by a regulator. Broadly speaking, however, the aforementioned articulation is an explanation that an adviser should have to make only to a client, and not to a regulator. Additionally, the nature of the fee mechanism…a percentage of account value…in a managed account provides a natural incentive to the adviser so compensated to perform on behalf of the account in a way that it makes as much money as possible. However, even if he is not motivated on that basis to act appropriately, the client, again, has ample opportunity to address whatever problem he feels that poses directly with the adviser.

Financial services regulation continues down the unfortunate and intellectually dishonest path of deciding that consumers of financial services…adults who are otherwise permitted to breed, drive cars, choose leaders, consume alcohol, carry guns, and enjoy a host of other responsibilities befitting a grown-up population…should be regarded as five-year-old children the moment they open a brokerage account or buy a mutual fund. I say “intellectually dishonest” because I do not hold for a minute that regulators really believe, philosophically, that investors are incapable of handling issues like this on their own, in the fashion I suggested. However, it is in the selfish interests of regulators that they decide that as much as possible is a formal offense for which brokers and advisors can be sanctioned and, more importantly, fined, in order that financial advisers of all kinds can be further bullied into doing their part to help feed the very beasts that seek to devour them.

The ONLY Way You Should Be Training the Heavy Bag is By Intervals

by Robert G. Yetman, Jr.

A fellow who’s been interested in my writings on combat fitness and self-defense training for some time, and particularly interested in my love for heavy bag workouts, was picking my brain about his training and what, if anything, he might be doing wrong. I asked him for some specifics about his regimen, and when he told me how he was training not only the heavy bag, but how he was training his cardio, more generally, I learned right away that he was making one of the biggest mistakes anyone can make: He has been training for endurance, rather than for shorter bursts of high-intensity effort.

In a self-defense situation, the need for endurance over a period of several minutes is just not there – that’s just not how a street assault plays out. Physical confrontations on the street will last a handful of seconds, but don’t let that very brief length of time fool you – during those few seconds, the combination of adrenaline and exertion required to defend yourself will likely put you in a state of oxygen deprivation…and it will be your ability to persist and keep fighting through that condition that may well prove to be the difference between escaping with your life, and some much less fortunate outcome.

Let’s talk about training the heavy bag, as an example. The fellow I referenced earlier indicated to me that his heavy bag sessions are each 45 minutes in length. That’s how he started describing them to me, and, as soon as he said that, I sensed immediately that something was wrong. I have been training the heavy bag for decades now, and there is no way (maybe it is just me) that a heavy bag session done the way I do it would ever allow me to persist for a duration of 45 minutes.

In my years as a Certified Fitness Trainer, I have been around a LOT of people who train that apparatus the wrong way. The best way to train it is to simulate real-life fighting conditions as much as possible, with maybe one or two modifications. In a real fight, will you find yourself ambling around your opponent and throwing out jabs and kicks on an irregular basis…or will you be heavily engaged, and having to fight furiously? Unquestionably, it will be the latter, so, if that is the case, then that is how you should train.

I perform several heavy bag sessions each week as a part of my overall training, but the individual sessions last no more than 15 minutes, total; as hard and as fast as I go at the bag, there is really no way that I could maintain the effort much past that point; more specifically, I will typically train in intervals of two minutes on, and 30 seconds off. That is, I will go at the back as hard as I can for two minutes, and rest for 30 seconds. After six rounds of that, I have basically sapped all of the resources I brought to the session that allow me to train at an appropriate level of quality.

Now, it is important to make a note here: it is not that I literally could not continue to punch and kick the bag after the six two-minute rounds are up…I certainly could…but I have found, given the way that I train, that the value of the training, at that point, becomes subject to a sort of diminishing returns. Again, I am not interested in endurance training, per se; I am interested in being able to maintain a high degree of effort over shorter periods of time, and so that is the endstate for which I train.

As for bag training, one of the tools you will find particularly useful is a round timer, and the one I use is a Gymboss (www.gymboss.com). Gymboss interval timers are small, relatively inexpensive interval timers that help to “clarify” the workouts for so many who want to get the most out of the time they spend training. The basic model, which should be fine for most folks, runs about $20. I have been including interval training in my various regimens for as far back as I can remember, and, for some types of training, like heavy bag for self-defense, it is really the only way to go.

This concept applies to your cardio training, more generally, as well. There is nothing wrong with jogging for a half-hour or so to build up endurance, of a kind, but you should also be sure to train any cardio in intervals, as well – that is, mixing shorter bursts of high-intensity effort with also-short periods of rest or relaxed effort. Your goal is to prepare to fight like crazy for brief periods, and all of the long, slow cardio training in the world will not prepare you for that.

Cashier’s Checks vs. Certified Checks: One and the Same…Or No?

by Robert G. Yetman, Jr.

Many people have come to use the terms “certified check” and “cashier’s check” interchangeably, as though they are precisely the same thing. Well, while the differences between the two are not substantial, they can be important, which means it is important for you to know those differences before deciding how you want to be paid.

Lots of us have engaged in private transactions for goods we own…cars, furniture, etc….and have had to address at the outset the manner in which we would like to be paid. Understandably, some buyers have no interest in walking around with large sums of cash on them, but neither do we want to fork over valuable merchandise to someone who presents a personal check, either (particularly on a weekend, when the ability to check on “good” funds is often not possible). One of the time-honored traditions of being paid is to arrange for the buyer to bring some kind of negotiable instrument that is more substantial than a personal check…and usually that is either a certified or cashier’s check. However, it is important to note that certified and cashier’s checks are not one and the same, and that if you are in a position to demand payment in either form, you should generally opt for the cashier’s check. Here’s why:

A certified check is basically a negotiable declaration issued by the bank that certifies your account contains the money required to make good on the check, and that the signature on the check is yours. The bank basically sets aside the money within your account to pay the check. However, a cashier’s check is issued against the escrow account of the bank itself – your money is moved from your account to the bank’s, but the check is written against the bank’s account. As a result, the bank essentially absorbs the liability for the check, which means you have greater recourse if there’s a problem with it.

In theory, then, cashier’s checks are more secure (for you) forms of payment than certified checks, but here’s the wrinkle with that: Nowadays, with the continued evolution in quality of technology tools, it is becoming easier to counterfeit both certified and cashier’s checks, which can mean big problems for you, particularly if the planned transaction is due to take place on a weekend.

There are a few precautions you can take, regardless of how you want to be paid, and I would definitely take them. First, when possible, plan to meet the buyer at his bank when he goes to have the check drawn up. If that is not possible, you need to at least conduct the transaction in a way that permits you the opportunity to first verify available funds from the bank – this pertains to both certified and cashier’s checks.

I would make it clear to the prospective buyer at the outset that you have every intention of verifying funds before completing the transaction. If you get any “push back” as a reaction, that may well be your cue that the guy (or gal) is up to no good. Any reasonable, honest person these days understands how rampant fraud activity is, and will not bat an eye at your taking extra precautions to ensure a safe transaction.

It is a shame that you cannot even trust an apparently-real cashier’s check to actually be real, but that’s the way it is. Your overriding concern is to protect yourself, and not worry about hurt feelings, inconvenience, or anything else that will ultimately pale in comparison to the heartbreak you’ll suffer if you end up losing your valuable merchandise in exchange for a bad check of any kind.

Stay Safe When Buying from a Craigslist Ad

by Robert G. Yetman, Jr.

Craigslist is another of those consummate double-edged swords – a wonderful way to transact business for goods and services, but in an entirely uncharted, unregulated, and unsupervised way. Craigslist can boast about all of their safe, successful transactions all they want, but to people like me (and probably you), we are just as…if not more…interested in how safe we and our loved ones will be during the course of the actual interactions with strangers.

According to an industry watchdog group, Advanced Interactive Media, Craigslist recently had the dubious distinction of crossing above the 100-murder threshold, when a 22-year-old man in Indiana killed a couple who had shown up intending to buy his car from an add he placed on the popular website.

There have been high-profile incidents related to Craigslist that make the news from time to time, including the case of Philip Markoff, the so-called “Craigslist killer,” who allegedly robbed three women…and killing one of them…after arranging to meet them through the Craigslist “personals” section. However, the reality is that whatever number of unfortunate incidents are recorded, there are likely many more that simply go unreported, and all of those combined surely means that doing business on Craiglist can be fraught with risk, if you do not adhere to some good, basic “rules of the road.”

Anyone legit will be able to answer any questions you have, and right away. Before meeting someone about a possible Craigslist purchase, you will want to ask a lot of questions about the item he has for sale. There are two reasons you want to ask these questions: first, as the prospective buyer, you simply want to know as much as you can in advance about what you’re thinking of purchasing, but, additionally, asking a lot of questions will help you to determine the legitimacy of the possible transaction. A person who is sincerely selling an item will unhesitatingly be able to answer your questions about it, and anyone who hits you with a lot of hemming and hawing, or, “I’ll have to get back to you on that,” may well be sending a worrisome signal of one kind or another.

Get as much info as you can about the seller, and then get to Googling it. Whenever I receive a call from a telephone number I do not recognize, I generally do not answer the call, but do whatever research I can about the number first. As a matter of fact, whenever I am preparing to do any business with anyplace these days, I will thoroughly research the person or business as much as I can. That’s the beauty of the Internet – you can do that kind of useful legwork with the great ease. In addition to a full name, find out where they’re from (at least the city/state), phone number (if the person will not give it to you, that is a very bad sign) and anything else pertinent, and start researching. Don’t forget checking for any social media accounts he may have, as well – leave no stone unturned.

Always, always agree to meet during the day, in a public place, and bring company. To some degree, what you’re thinking of purchasing may influence just how public a place it is in which you can meet; for example, if you’re buying a boat, you’re not likely going to be able to meet the seller on the front steps of the local library. One way to limit your risk is to always bring a companion with you. A good way to handle this, from a tactical standpoint, is to have the person you bring hang back at least several yards, perhaps making a phone call – this way, if there is trouble, the two of you are less likely to be compromised simultaneously.

Whenever possible, be armed. This is one of the many reasons I don’t see myself ever living in a state with restrictive gun laws. Whenever you show up to a meeting like this, you (and, ideally, your companion) should always be armed. If your local laws do not allow for the possession of a firearm, find out what you can legally have on your person, and make sure you have it.

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Is It REALLY Possible for the “Average Person” to Retire Early?

by Robert G. Yetman, Jr.

When we read stories about average people who do extraordinary things in the realm of personal finance…like paying down a mountain of debt in a handful of years…we, understandably, tend to question the veracity of such claims. The stories are often accompanied by photos of the principals, and they all look great: happy, healthy, often young…and without a trace of having gone through any of the hardship associated with what it takes to accomplish such amazing feats.

As I said, we often read these kinds of stories in conjunction with the issue of paying down debt, but we will also see them now in relation to retiring well before typical retirement age…65, 70, whatever. In fact, you don’t have to look around very hard to find a growing body of articles that discuss the subject of retiring in one’s 30’s. Part of what makes the articles so interesting…just as with the articles on paying down huge sums of debt in short order…is how relatively stress-free the process seems to be for so many engaging in it.

So, what’s going on here, and is it really possible to retire decades earlier than your peers?

The answer is “yes, it is possible,” but an important caveat is that you pretty much have to have decided that such is your goal almost as soon as you begin life as a working adult. The reason is that between what you have to set aside, and the lifestyle choices you make to accommodate what you need to set aside, you really have no choice but to embark on this path as early as possible. The reason comes back to math, as so much in life seems to; math, conjoined with reality, prevents an average person making a typical salary for his profession from beginning this journey at, say, age 30, in order to be financially independent by age 40. It is simply not possible.

The underlying issue seems to be, what it takes to accumulate $1 million in savings at an age appreciably younger than 65. Looking at the issue broadly, it comes down to this: having the ability to set aside at least 30 percent of your income for a little more than a couple of decades. If you can do this, you should no longer be “job-dependent” at that time, assuming you are also willing to live a financially-prudent lifestyle.

Here is an illustration: Let’s say that your average salary over the course of your working life is $60,000 per year. Taking into account the realities that, as an average, what you can set aside, in dollars, will likely be lower towards the beginning of your working life and higher at the end, we can assume you will be able to put away $1500 per month as a function of your 30 percent savings effort. Do that for 23 years in a diversified portfolio of investments that generates an average annual return of seven percent, and you will have your $1 million in savings.

Now, depending on how you choose to live, that should be enough to sustain you, but what it also does is provide you with greater flexibility to live a life that is somewhere in between having a daily, rigid employee obligation and needing to generate no additional income whatsoever. For example, if you would like to live a little better than what your $1 million in savings can provide, a part-time, work-from-home opportunity could be a perfect fit for you.

Setting aside a minimum of 30 percent of your gross income is the key here, and the more you earn, the better this works – living on just 70 percent of your income is a lot easier if you make $100,000 per year, compared to if you bring in $40,000 per year. On that note, you cannot realistically expect to succeed at this if you are content to exist at the bottom of the career food chain for the duration of your working life.

The lessons here are not just for the benefit of the very young who, beginning this effort at that age, actually have a shot of no longer needing to work by age 40; they also apply to that person of more advanced years who nevertheless seeks to be unburdened by work obligations sooner, rather than later. Admittedly, it can be more challenging, initially, for that person to reconfigure his life in a way that allows him to set aside his 30 percent, but, when it comes right down to it, much of that has to do with a willingness to make the necessary choices, rather than a genuine inability to do so.

The point here is that if you are willing to live in a way that allows you to set aside 30 percent of what you earn into your retirement savings (if that’s what you call it), and you can do so for a little over 20 years, you will, thereafter, enjoy financial freedom of a kind that you were otherwise not destined to realize.

Can You Inherit Debt?

by Robert G. Yetman, Jr.

One of the questions people are now asking with increasing frequency as their parents age is, “Who is responsible for their debt when they pass on?” The question is of greater concern now than it used to be, because more elderly folks are making ongoing debt obligations a part of their financial profiles. This was not the case many decades ago, but a number of factors, including a more challenging economy and a greater “philosophical” acceptance of debt, overall, have conspired to cause more and more people to leave debt obligations behind at the event of their passing. Accordingly, more loved ones, children as well as spouses, are taking a greater interest in this subject.

For starters, whatever assets you have when you die will be liquidated to meet your debt obligations. If you have no debt, then no worries, obviously, and if you have a little debt, then only what is needed to pay off that sum will be given over to those you owe. What happens, though, if you have a substantial credit card balance, and what you leave behind in assets is not enough to cover it?

The short answer, and good news for those who remain, is that unless others are co-signers on whatever the obligation at issue is, no one else can be held legally responsible for the debts, and that includes spouses and family members. This reality also includes “authorized users” of credit cards, as well. The bottom line is that unless an actual obligation is in your name, you have no responsibility to repay a debt.

Those left behind in these situations may hear from the credit companies to see about payment, particularly if the amounts owed by the deceased are large, but, again, there is no obligation on their part to actually pay anything. That said, because because the executor is responsible for paying as much of the debt obligation as possible with the assets left behind, if the debt exceeds the amount of the assets, then there is likely no money available for distribution to heirs.

There is one important exception to the previous paragraph. Any asset that avoids probate is generally considered to exist outside of the estate. For example, IRAs, 401(k)s, beneficiary payments from insurance policies, even fully-taxable brokerage accounts that are set up with a TOD (transfer of death) provision that allows the naming of a beneficiary to the account…live outside of an estate, for the purpose of asset distribution. However, any assets that are a part of the estate are fair game for those to whom you owe money.

As for obligations that represent secured debt, like a mortgage and car loans, the goods associated with those will be subject to reclaim by the bank, assuming the loans attached to them were solely in the name of the deceased and no one takes over the obligations. Spouses will generally have the opportunity to refinance secured debt like this in their own names, which means that the death of a spouse in whose name the relevant obligation solely existed does not necessarily translate to the house or vehicle automatically going back to the bank. However, if that does not happen, and payments are not continued, the house, car, etc., will be repossessed.

So, the good news, generally speaking, is that any debts for which you were not legally obligated to begin with…do not become yours due to the passing of someone close to you, even if that person was a spouse or a parent. There is one more component to this I want to discuss, however, before we leave this subject behind – it has to do with continuing to use a credit card as an authorized user after the account holder has died.

In some cases, the person doing it may not necessarily realize, in the midst of his grief, that he’s doing something wrong. When people die, a spouse may use the card to buy groceries and pay for incidental expenses, not realizing the legal ramifications of doing so. However, you should know that any charges you rack up after the passing of the account holder are your responsibility, and, what’s more, you’ve given the credit card issuer a potential “in” to try to hold you responsible for the debt that was incurred before the account holder’s death. Bottom line: the card should not be used by anyone once the account holder has passed away.

Problems can even arise stemming from charges made when an account holder was alive but nearing death. If an account holder knows his death is imminent, and uses the card in a way that those close to him benefit from his “generosity,” such as securing cash advances in order to give money to kids or grandkids, or using the card(s) to buy a car for a child or spouse, those recipients can be held responsible for what they received if the deceased’s estate is not sufficient to cover the total of his obligations.

Those kinds of situations aside, however, the bottom line remains that the death of someone to whom you are connected in the familial sense does not mean you are now legally bound to honor their obligations – you’re not.

The Logical Eventualities to “Everyone Should Have a College Degree”

by Robert G. Yetman, Jr.

No doubt many of you saw this exchange recently between Neil Cavuto and Keely Summers, national organizer of the Million Student March. If not, here it is. Enjoy yourselves.

For now, let’s set aside the fact that Mullen and her rantings represent the best justification seen in a while for raising the minimum voting age in this country to 50. Let’s instead talk about a component to this overall discussion that can be all-too-easily missed: the very idea that that a college education should be available to everyone.

One of the core ideas that serve as the basis for the militant blathering of people like Ms. Summers is that everyone should have a college education. Fair enough; let’s say, for the sake of discussion, that everyone has a college degree (I’m talking about a bachelor’s degree here, which is what we all really mean when we say “college degree”). Now what?

The natural eventuality of each and every one of us having a degree is that said degree becomes worthless, as far as its role as a conduit to careers for which having a degree is genuinely appropriate…and instead becomes little more than a very expensive high school diploma. If everyone has a degree, then that means, well, everyone has a degree, including the guy who fixes your car, the electrician who rewires your house, and the lawn maintenance worker who trims your hedges. The need for people to perform those jobs doesn’t go away because everyone in the country now has a bachelor’s degree. How does the four-year degree assist those professionals in doing their jobs? What, exactly, is derived from the pursuit of a four-year degree that helps your auto mechanic repair your transmission? How does it help the sheet metal worker? The welder? The machinist? The roofer? The emergency medical technician?

We have dishonestly allowed the “everyone should have a college degree” narrative to supplant common sense thinking, when it comes to the subject of the economic infrastructure of the country, as well as the personal economic well-being of individuals and families. It is a narrative that has done a great disservice to the common man, as it has acted to emotionally and psychologically leverage him and his children into unconscionable sums of debt on the basis that his son or daughter simply must have a college degree in order to economically succeed. It ignores the reality that there remain all kinds of “no-college-needed” jobs available that provide much more than a mere living wage. Access to some such jobs may require more than on-the-job training, like a certification from a vocational school or local community college, but the point is that there are plenty of jobs out there that can be had for an initial investment of time and money far, far less than that which is required to obtain a bachelor’s degree.

Sadly, countless numbers of companies and organizations are complicit in this, as well, now demanding applicants come to the table with bachelor’s degrees when applying for positions for which having a degree is obviously not necessary.

A collateral component to this concerns the quality of the college education received by the average person if, again, everyone has a college degree. Traditionally, college was not for everyone, and not because of a lack of access to funding (although that has certainly been one of the barriers for many). College has not been for everyone, traditionally, because it was reserved for the more academically qualified among us. Exclusion is supposed to be an inherent feature of gaining acceptance to college. I’m well aware that the concept of exclusion is very much out of step with the progressive social narrative of the day, but that narrative has, with very few exceptions, poorly served the nation, overall. If lack of money is a barrier to attending college, there are a variety of ways to ably deal with that problem, even in this age of astronomical tuitions at many schools; however, if you don’t genuinely belong at college on the basis of your qualifications, interests, and goals, you are due to rethink why you’re there at all.

To be fair, the cost of college in this country is a distinct problem, but the underlying reasons for that should be the focus of our consideration, rather than who should pay for costs that should not exist in the first place. There are a variety of ways to address that issue, to include bringing back bankruptcy protection for new student debt; what do you think colleges would be able to charge for tuition if their enablers, the lenders of all that money, were suddenly at risk of being on the ass-end of defaults? Another part to addressing the problem? Work to reconnect society with the traditions and ideals of higher education, and, in the process, change the narrative that everyone should have a degree, a narrative that has already gone a long way to financially debilitating generations of our citizens.