The Third Deadly Sin

Greed may have marked the upward surge of mankind, but combine it with unbridled innovation and excess leverage and the results can be deadly.

Near the end of each year, a group of us meets for lunch at Antoni’s Italian Café in the Oil Center. We gather at the round corner table, where we talk about the local economy, politics and business. When we met at the end of last year, we were all very eager to say goodbye to 2009, and welcome what we hope will be a much better 2010.

During lunch, Andy, whom I have known for over 40 years, asked for my forecast for the financial markets during 2010. I am old enough to know that none of us is very good at predicting short-term market movements. However, the events of the last couple of years provided fodder for a lively discussion about our economic future. All of us feared that the U.S. could be faced with continued volatility, a weaker dollar, higher than usual unemployment and an increase in interest rates. We agreed that the next few years could be both difficult and volatile for most people living in America.

While monitoring our investments should be a continuous process, the beginning of a New Year can be an excellent time for investors to take a hard look at our portfolios, and to determine the most appropriate investment strategy for the coming year. As part of the process, it is appropriate to ask, “Have the fundamentals of our economy changed?” If so, “What changes should I make in order to help to protect my investments?”

In years past, we have had investment managers tell us that “this time is different,” only to discover that things hadn’t really changed. That may still be the case, but some of the key factors that drive stock prices and movements of the markets have evolved at an escalating rate over the last 25 years. Many advisers believe it is appropriate to focus on how these changes could impact the future prices of the shares of stock we own.

For example, let’s take a look at the combined impact of three of those factors: greed, leverage and innovation. Some people will go to almost any lengths to attain a profit — even if they are doing so at someone else’s expense. A notable example is the published report that Somali pirates have created a stock exchange to manage their ill gotten booty. According to Reuters, these banes of the Gulf of Aden have been attracting investors, who provide cash for weapons and support to the pirates, in exchange for a share of the ransom obtained from captured ships. So much for innovation!

While none of us would dare travel to the coastal town of Haradheere, Somalia, where this execrable market is located, we should be aware of new market forces closer to home that can affect our investment decisions.

What about leverage? The members of our group who gathered at Antoni’s are all old enough to remember a turning point for the uncontrolled use of leverage. In 1978, a genius in corporate finance named Michael Milken established a Los Angeles office for investment bank Drexel Burnham Lambert. Milken promoted the use of junk bonds to create high levels of debt leverage in order to control and acquire some of the best known corporate brands in America. His deals included Revlon, Beatrice, National Can, Fruit of the Loom, MCI and Fox. The substantial leverage created by junk bonds allowed entrepreneurs to raise billions of dollars and literally gain control of large companies without risking a dime of their own capital. “Greenmailers” were able to use leveraged buyouts to take over companies, often at the expense of stockholders and employees. Even after Milken was released from prison, the excessive use of leverage continued to disrupt the financial markets. Over the last decade, risk premiums declined to unrealistically low levels, allowing the use of leverage to increase, adding even more risk and volatility to the markets.

Another major strategy that has impacted stockholders over the last 15 years was the widespread use of stock options in order to attract, retain and reward key executives and management. The issuance of these options, initially by technology companies during the early ’90s, was designed to “align” the interests of shareholders and key management personnel. However, the excessive use of these options diluted shareholder equity, and, in the opinion of some, set the stage for corporate greed and the concentration of the control of those corporations.

More recently, banks were able to use newly created conduit entities that were not part of their published balance sheets in order to minimize levels of regulatory capital. These structured investment vehicles, which are considered by a group of analysts to be part of “the shadow banking system,” created a complex web of contingent funding lines and partial guarantees. Later, when fully recognized, these SIVs reduced the capital ratios of these institutions, diminishing shareholder value and causing market disruption.

During the last decade, the proliferation in the use of various types of derivatives has not only eased the barriers to market entry, but also changed the ways that we conduct business. Today, many individual and institutional investors spend more of their time and resources trading derivatives than they do the underlying traditional products and equities that they represent. The use of these instruments can cause disproportionate swings in traditional markets.

Increased volatility and many of our current economic problems are in part the results of combinations of unbridled innovation, greed and excess leverage. You may recall the statement made by the character Gordon Gekko in the movie Wall Street: “The point is, ladies and gentlemen, that greed — for lack of a better word — is good”… “Greed, in all of its forms — greed for life, for money, for love, knowledge — has marked the upward surge of mankind.” I do not believe that this is what Adam Smith had in mind when he referred to the “invisible hand” in The Wealth of Nations. The recent past has taught us that greed is not always good. When combined with innovation and excessive leverage, greed can cause widespread market disequilibrium. Unfortunately, it may take years for these imbalances to correct and for investors to recover their losses.

Back at Antoni’s, our lunch group ended up finishing our cappuccino and leaving without solving any of the world’s financial problems. We agreed to save that task for next year.

We did end up agreeing that, while our ultimate financial destination hasn’t changed, our strategy may have to be modified in order to deal with the new realities and imbalances in our economy. In addition to researching business plans and financial statements, investors should keep an eye on corporate takeover action, leverage and footnotes to corporate financial statements. It is important to remember that globalization, business changes, world terrorism and legislation will all impact the value of our investments. We should follow currencies, commodities, interest rates and employment data — and try to determine how they will affect the values of the stocks and bonds we own. While structuring a portfolio was never easy, selecting and monitoring equities could be even more challenging during the next decade.

Good luck, and happy 2010!

Dave Romagosa is a registered principal with, and offers securities through, LPL Financial, a member of FINRA and SPIC. He is president of Cornerstone Financial Group and has been a financial adviser in Lafayette since 1969. He has a master’s degree in financial services and holds the Certified Financial Planner designation. He is a member of the adjunct faculty at UL Lafayette, where he teaches a course in finance.