Almost exactly one year ago, I interviewed Joseph Collorafi, division chief of the New York regional office of the U. S. Department of Veterans Affairs and former National Guard lieutenant colonel, as part of the background research for my master’s project:

Iraq Vets: still fighting, but now it’s with the Veterans Administration

http://www.susansipprelle.com/iraqvetsPH.htm

“Budgetary constraints affect resources,” Collorafi said.

He also spoke about the VA’s lack of sufficient manpower to service the newest generation of veterans:

“We should have planned better.  No one thought we’d be here [in Iraq and Afghanistan] four years plus.”

This week, Collorafi and five additional senior managers were removed from their positions at the New York regional office, which serves about 800,000 veterans.

They have been accused of shredding documents and changing the dates on veterans’ applications to make it appear that their claims were being processed more quickly.

The story was reported by Newsday:

http://www.newsday.com/news/printedition/longisland/ny-liva22235939106nov23,0,5524668.story?track=rss

and the Albany Times Union:

http://timesunion.com/AspStories/story.asp?storyID=738821

This treatment of veterans and their claims is OUTRAGEOUS!

One of the veterans I profiled waited over six months for an answer on his PTSD disability claim application.  He had been diagnosed with and treated for PTSD by the VA.

His PTSD disability claim,  submitted to the New York regional office, was eventually denied.

How could it be denied when the VA itself was treating him for PTSD?  Makes one wonder what happened to his paperwork.

He has now filed an appeal, but the wait for appeals to be processed is even more lengthy than for original claims.

What’s happening today?

As I write, the global financial markets are caught in a downward vortex.  This cycle was triggered initially by the rise in defaults of subprime mortgages in the United States (See prior post:  “The Bailout”), but has  spread to stocks, corporate debt, leveraged loans, etc. and become global in scope.

The linkage has been an over-leveraged global financial system.

Most global banks and financial institutions borrowed too much money to make loans of all types - mortgages, credit cards, student loans, leveraged buyout loans, loans to emerging market countries and companies, you name it.

Not only have financial institutions borrowed too much, many investments banks borrowed $30 to $40 for each dollar of equity or investor capital on their balance sheets, but also much of this borrowing was very short term and due to be repaid in less than a year.

When investors became alarmed at the risks that many banks were running, it became difficult/impossible to roll over maturing debt and banks had to sell assets (loans) to raise cash.  Many banks took all of these actions more or less simultaneously.  Consequently, the value of the assets for sale dropped dramatically and the banks began to take large losses, which worsened investor perception of risk … and so on.

Globally, governments have stepped in to break this cycle before the entire financial system collapsed and we reverted to the Stone Age with a cash or barter economy.  Governments around the world have bought stock in their own large banks to boost public confidence in the banks’ viability and to allow the banks to pare down debt without selling more of their assets (loans).  Governments have also guaranteed bank borrowings, so banks can roll over their debts.  Finally, governments have forced weaker banks to merge with stronger ones.

It is a reasonable bet that this approach has staved off systemic collapse, although the reality remains that too much debt has been created and that a significant amount of it is not going to be repaid in full.  As consumers and companies pull back on spending to increase saving or pay down debt, Main Street, the real economy, will suffer as aggregate demand for goods and services drops.  As a result, we are undoubtedly, going to have a severe recession in the developed world and, perhaps, globally.

Did Hedge Funds Do This?

Hedge funds have gotten a lot of attention, but have been peripheral to the crisis.  You’ll notice that the major financial institutions that have gotten into trouble are banks, among the most highly regulated institutions on the planet.

Regulators and bank managements were asleep at the switch and failed to notice how the world and risk were changing.  (This narcolepsy isn’t political or ideological and goes back at least 15 years.)

Hedge funds do invest with borrowed money, and they have been selling securities to pay down debt, but so have corporate CEOs who borrowed against their holdings of company stock and big retirement funds, like Calpers, which is selling stock to meet future commitments to invest in leveraged buyout funds.

So far, unlike 1998, no single hedge fund has become a radioactive systemic risk.  The financial hall of shame has dozens of new members, but they are mostly commercial and investment banks, AIG (the world’s largest insurance company) and the enablers of these financial institutions  — the credit rating agencies (Moody’s and Standard & Poor’s), and the regulators.

What Lies Ahead for Hedge Funds?

Like all other sectors of the financial world, the hedge fund industry is going to be transformed.  It will shrink dramatically and borrow less money on a longer-term basis.

But this is an adjustment that all of us will have to make as the world recalibrates to a world of more costly and less available credit.

The transition to an economy that saves more and invests more is painful, but, if supported by thoughtful and creative government policy, can lead us to a better balanced, although more sober economic future … and maybe even to a more competitive America with a higher sustainable long term economic growth path that elevates living standards for everyone.

However, there is a significant risk that government will fight the last war, propping up a rickety and obsolete consumption-driven economy with yet more debt (government debt this time) because our governmental leaders fear that we Americans can’t bear to hear the truth.

I am keeping my fingers crossed.

Dwight Sipprelle can be reached directly at dsipprelle@gmail.com.

In the preceding post, I mentioned that hedge funds can borrow money to increase the size of their bets.  This is called leverage.

Leverage means that if a hedge fund likes stocks, for example, but only has $1 million of investor capital, the fund can borrow money from banks to buy more stocks - sometimes as much as ten times its investor capital.

In this instance, a hedge fund with $1 million of investor capital and $10 million of borrowed money could buy a total of $11 million of stock.

The fund’s Balance Sheet would look like this:

Assets                                                 Debt

$11,000,000 stocks                           $10,000,000 bank loan

                                                       Capital

                                              $1,000,000 investor capital

_______________________                     _______________________________

$11,000,000 total assets                  $11,000,000 debt + investor capital

This structure works wonderfully for the hedge fund if stocks go up in value at a rate higher than the borrowing cost of the bank debt.

To illustrate, let’s assume stocks go up 10 percent over the course of the year, and the cost of bank borrowing is five percent.  In the above example, the hedge fund owns $11 million of stock that goes up 10 percent.  At the end of the year, its stock portfolio is now worth $12.1 million (an increase of 10 percent).  The hedge fund also pays the bank its five percent interest on the borrowed $10 million, or $500,000 of interest expense.

The difference between the increase in the value of the stock portfolio and the interest expense on the bank borrowing is the net investment income of the hedge fund for the year.

The fund’s Income Statement would look like this:

                        $1,100,000 increase in value of stocks
                          (500,000) interest expense on borrowings
                        _______________________________________                                                                                                    ___________________________________________

                         $600,000 net investment return

Since the fund started with $1 million of investor capital, the $600,000 net investment income is the equivalent of a 60 percent return for the year.  Not bad when it works.

Note that the fund returned 60 percent versus the 10 percent return for the stock market.
The hedge fund also keeps 20 percent of the $600,000 for itself and probably raises a lot of new investor capital for the following year because its returns were so high.

However, this much leverage/borrowing is a disaster if stocks go down and can easily wipe the fund out.  Stocks only have to go down more than 4.55 percent to bankrupt the fund.  A decline of 4.55 percent on $11 million of stocks and the $500,000 of interest expense owed to the bank allows the bank to recover its loan plus interest, but completely destroys the investor capital base.  Investors get nothing back, down 100 percent.

Dwight Sipprelle can be reached directly at dsipprelle@gmail.com.

PART I: What are hedge funds?

Like any industry that charges high fees, Wall Street has its share of cryptic language to add mystery to what is actually a straightforward business.  In the current economic environment, which almost no one forecast, hedge funds have been identified as the principal culprit behind the mess.

So what’s the deal?

Hedge funds are managed pools of investment assets like a common mutual fund with a few key differences:

Mutual Funds:

• Have a tightly defined investment objective, such as energy stocks or investment grade corporate securities.

• Own securities. They don’t short  — sell shares they don’t own in hopes of buying them back at a lower price.

• Charge a fixed annual fee (around 1.25% of your investment for a stock fund), regardless of the performance of the fund.

• Are allowed to advertise.

• Are allowed to accept investments from anybody.

Hedge Funds:

• Generally have a wide and flexible investment objectives.

• Can own or short almost anything in the fund, including stocks, bonds, currencies, real estate, commodities and derivatives.*  Hedge funds also borrow money to increase the size of their bets.  That means, if they like stocks, but only have $1 million of investor capital, they can borrow money from banks to buy more stocks - sometimes as much as 10 times their investor capital (See next post on leverage).

• Typically charge an annual investment fee of 1 to 2 % of your investment and, in addition, get to keep 20 percent of the net investment return for themselves.  Often, the fund managers have a significant amount of their own money invested in the fund.

• Are not allowed to advertise.

• Most hedge funds in the U.S. are registered, which means they are regulated by the SEC and can only accept money to manage from very rich folks or institutions such as pension funds, insurance companies or university endowments.

What’s their track record?

The history of the hedge fund industry has been pretty good, on average.  Year after year, hedge funds have significantly outperformed stock mutual funds.  Even this year, when the stock market is down 40 percent so far, hedge funds are down 15 to 20 percent, as an industry …

Not great, but certainly better than stock mutual funds.

The notoriety surrounding hedge funds stems from:

• their private nature. Unlike mutual funds that publicly report their securities holdings every three months, hedge funds divulge little about their investment strategies.

• their sometimes aggressive behavior vis a vis companies in which they invest.

• the extremely high compensation that can accrue to a successful manager with a large fund. There are instances of individuals making over $1 billion in a single year. This level of compensation arises from the 20 percent of the net performance fee that funds retain at the end of the year. Of course, investors received the other 80 percent of the return.

Finally, of course, hedge funds do blow up from time to time.  When you use any kind of leverage or borrowing to amplify the returns in a fund, it is possible to lose all of your investors’ money if your bets are incorrect.  Most famously, LTCM, a large hedge fund founded by Nobel prize winners  had to be rescued in 1998 by a consortium of banks organized by the Federal Reserve.

———————-

* Derivatives are merely financial contracts whose value is based (derived) from something else, like a stock or a bond.

Example:  Today (written on November 7) Assume Johnson & Johnson (JNJ) is trading at $60.00/share.  If I think that by 12/20/08 (43 days), JNJ will be trading at $65.00/share, I can buy a call option (derivative) that entitles me to buy JNJ on 12/20/08 at $65.00, regardless of where it’s actually trading on that day.  I can buy that option today (11/07/08) for $0.95/share.

If I am right and the JNJ stock trades above $65.00/share on 12/20/08, I take my call option and $65.00 and get one share of JNJ. (The stock will have to trade above $65.95/share for me to make money because the call option cost me $0.95/share.)

If I am wrong and the stock trades below $65.00/share on 12/20/08, the call option becomes worthless, and I lose my $0.95.

Dwight Sipprelle can be reached directly at dsipprelle@gmail.com.

My husband and four kids chattered and laughed as we neared the rendezvous point with the dog sledding outfitters, but I kept quiet.  They were eager to try this new winter activity.  I was not.  I don’t like to get cold, and I don’t like taking risks.

My thoughts also kept returning to our 14-year-old daughter. We’d left her behind at the guest ranch where we staying over the holidays.  She was recuperating from a skiing injury and couldn’t be bumped around without renewed pain.  She was content to remain at the lodge, watching movies and sipping hot chocolate, but I hate our family to be separated.  I hadn’t descended into an evil mood, but I wasn’t in a happy, spunky one, either.

We reached a snow-covered parking lot where about 20 dogs, all chained to a beat-up truck, barked, yipped, whined and yapped.  One of the larger dogs (or, maybe, a half-wolf) sat down on his haunches, tilted his head back and howled into the clear blue western sky.  The yellow-brown fur on his back hung off in mangy patches.

In fact, not one of the dogs looked like it could star in “Balto” or run more than 100 yards, although they made such a racket my head ached.  They were small, skinny and seemed to be an underfed bunch of misfit mongrels.  We kept a nervous distance from the pack and held back our excited 3 year old, Lynne, who wanted to pet the doggies.

Chris, the owner of the team, strode over and introduced himself to us.  Well over six feet tall, he loomed over our family huddle. He wore a huge down parka with its fur-trimmed hood pulled up over his head.  Appropriate because the temperature was only about 10 degrees.  He told my husband Dwight the dogs were Alaskan huskies that could run up to 150 miles a day.

I kept my doubts to myself about the dogs’ strength and stamina. I consoled myself that if we rode more slowly, we would ride more safely.  Although we might freeze to death.

Chris had a helper who looked like he had just crawled out of one of Steamboat’s bars after a long night.  We nicknamed him Sleazy.

Chris and Sleazy began to unchain the dogs from the truck one by one.  The men grabbed the dogs by the scruffs of their necks and collars, and then they half-ran, half-dragged the dogs on their two hind legs up to three sleds waiting at the trailhead and buckled the dogs into their sled harnesses.

I thought that sled dogs would instantly obey their masters’ verbal commands and leap into their assigned slots.  These dogs jumped back and forth over chains and harnesses and each other while they fought, became tangled, and continued to yip, bark, howl, yelp, and whine at an unbearable decibel level.

I turned to Dwight in astonishment as Chris gestured first at me and then at one of the sleds.  “I’m driving?  I thought I was just going to be a passenger!”

“Guess not!” he said and grinned.

Over the cacophony of the dogs, we sorted ourselves into the three staked sleds with six dogs each.  I stood on the runners of one with our son Troy, age 9, wrapped in a blanket and cocooned into the zippered sled seat below me.  Dwight was our toddler Lynne’s driver.  Tyler, 16 years old, was the musher for his sister Clare, age 12.

Chris yelled simple driving instructions at us:  “Stand on the runners while moving.  Take one foot off the runner and place it on the center rubber mat to slow the dogs down.  Put both feet on the metal claw brake to stop the dogs. ”

He added, “The only tricky part of this trip is getting over the bump onto the trail.  Once you get going, we’ll stay out of sight with the snowmobiles.”

I was looking at my feet, figuring out their placement, trying to absorb the information and worrying.

Chris screamed, “Go, Susan!” as he unstaked my sled and freed the dogs to run.

At once, the dogs jerked forward.  My heart pounded as we careened over the bump onto the trail.  Immediately, the sled lurched to the left and began to skid along on its side with Troy still zipped tightly inside.  I fell off the tipped sled, scrambled to my feet and raced after it.  I caught up to it, grabbed the handle and threw my weight against the sled’s forward motion.  The dogs slowed, stopped, then burst into barking, howling and yelping again.

“Are you all right?” I screamed to Troy.

“Fine,” he answered with a huge smile.

Chris appeared beside me on his snowmobile.  A little late, I thought.  But he righted my sled, and we set off again, this time without incident.

Dwight and Tyler steered their sleds onto the trail without difficulty, and our long, cold, 13-mile ride along the North Fork Trail started.

The dogs ran along, now blessedly silent.  But they did not run smoothly and cooperatively, as I had imagined they would.  They ran raggedly.  Some trotted along evenly with their tails erect and their harnesses tight, pulling the sled.  Others scrabbled along on a diagonal line, tails drooping, bumping into their paired partner or the powdery bank along the edge of the trail.  My largest dog jogged erratically, vaguely contributing to the team-pulling effort.

Chris and Sleazy zoomed by us on their snowmobiles.  The dogs picked up their pace as the vehicles passed, then resumed a ragtag lope.  Now that I felt calmer, however, Troy and I chatted a bit.

We rounded a corner and found Sleazy parked next to the trail.  “We have to wait for the third sled,” he announced.

I felt confident enough to turn around because I was fully stopped with all my weight loaded onto the brake.  I saw Dwight and Lynne a short distance behind us, but no sign of Tyler and Clare.  My heart began to thud again, but then I spotted their sled cresting a small hill.  Their dogs were barely loping.

Chris (Where had he been?) joined Sleazy, and we all waited for Tyler and Clare to catch up.  Chris and Sleazy shifted around a couple of dogs to better balance them and told Tyler and Clare to lead now.

Again, the men zipped ahead on their snowmobiles.  The 18 dogs showed a brief spark of pep, then settled into their trademark sloppy pace.  Only now, with the two kids in the lead, I had to ride my rubber brake.

Tyler and Clare’s dogs stopped as soon as the trail began to slope uphill, turned around and looked at the kids, then stood around and sulked.  Tyler hopped off the sled, ran along beside it and yelled at them while holding onto the handle.  The dogs sped up for a few moments, then slowed again and again.

My hands and feet felt frozen and began to ache.  We were moving so slowly that I was standing with one foot on the runner and one foot on the brake to stay a reasonable distance behind the kids’ sled.  Ty and Clare yelled and groaned at their team.  Troy and Lynne, well bundled and comfortable, promptly fell asleep.

Sleazy popped out of nowhere and hollered at Ty and Clare not to yell at their team because their dogs were the youngest and most inexperienced.  I began to wonder if this expedition would end before I had frostbite.

After a long ride, we reached the trail’s turnaround point where Chris and Sleazy awaited us.  Chris grabbed the lead dogs of Ty and Clare’s sled and guided them easily around the smoothed loop.  Sleazy tugged my dogs into the powdery rough center of the turnaround, and my sled began to tilt, reminiscent of the journey’s start.

“Lady, get off the sled and push!” Sleazy hollered at me.

“I’m not feeling good about this!” I shouted, but no one was listening because Chris had allowed Clare to clamber onto her sled without loading anyone into the seat.  Her dogs (the same ones that had crept up the trail) now felt less weight and no restraint. They began to rocket homeward along the trail as fast as they could.  Chris sprang forward in an Olympian dive, and his bulk halted the dogs in their tracks.

Simultaneously, Dwight’s team spotted their buddies headed home and simply doubled back, parallel to their own sled, but facing the opposite direction and began to pull toward home, too.  Out of the corner of my eye, I saw his sled tipping over with Lynne in it, and I began to scream in panic, although Dwight remained calm and quickly regained control over his dogs.

Somehow, we all got straightened out, despite Sleazy.  Ty took over my sled as Troy’s driver; I climbed into Clare’s sled, gratefully pulled the blanket over me, and zipped the covers up to my nose.  Dwight had righted his own sled, and he and Lynne were underway.

We headed off downhill.  The dogs skidded along, eager as I was for this trip to be over.  Ty and Troy sped ahead.  Back at the ranch, Tyler told me that when he got out of the snowmobilers’ sight, he reached down into the sled, hauled Troy out onto the runners and let Troy drive, too.  Clare drove confidently, but I felt anxious because we were stuck with the sideways-leaning lead dog that kept pulling the other lead dog off course.  Precipices loomed next to us.

Clare complained about my back sled driving and mocked my fears about falling off the cliffs.  Dwight continued to guide his sled with unflappable insouciance.  When his sled neared ours, I shouted, “Is Lynne OK?”

“Still sleeping,” he responded calmly.  When Lynne did awaken, very near the end of the trip, she waved gaily at Clare and me. Her little bundled face beamed out at us from her covers.

As we approached the long, gentle downward slope at the end of the trail, I could see Ty and Troy in the distance.  From afar, their dogs appeared to pull gracefully and evenly. We were going to survive this adventure safely after all.  I relaxed and appreciated the magnificent beauty of Colorado.

Deep, powdery white snow sparkled under the morning sunlight.  The Rocky Mountains crested magnificently all around us.  We were alone with nature, no other humans in sight.

At that peaceful moment, our largest dog, without any fuss, opened his mouth and spewed yellow vomit all over the trail.  The other dogs, ignoring his issues, continued to run and simply dragged him onward to the trail’s end.

At long last, our family dog sledding trek was over.

I was sent this tale before the election:

BAR STOOL ECONOMICS

Suppose that every day, ten men go out for beer and the bill for all ten comes to $100.

If they paid their bill the way we pay our taxes, it would go something like this:

The first four men (the poorest) would pay nothing.
The fifth would pay $1.
The sixth would pay $3.
The seventh would pay $7.
The eighth would pay $12.
The ninth would pay $18.
The tenth man (the richest) would pay $59.

So, that’s what they decided to do. The ten men drank in the bar every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve.

‘Since you are all such good customers, he said, I’m going to reduce the cost of your daily beer by $20.

Drinks for the ten now cost just $80.

The group still wanted to pay their bill the way we pay our taxes so the first four men were unaffected. They would still drink for free.

But what about the other six men - the paying customers? How could they divide the $20 windfall so that everyone would get his ‘fair share?’

They realized that $20 divided by six is $3.33. But if they subtracted that from everybody’s share, then the fifth man and the sixth man would each end up being paid to drink his beer. So, the bar owner suggested that it would be fair to reduce each man’s bill by roughly the same amount, and he proceeded to work out the amounts each should pay.!

And so:

The fifth man, like the first four, now paid nothing (100% savings).
The sixth now paid $2 instead of $3 (33%savings).
The seventh now pay $5 instead of $7 (28%savings).
The eighth now paid $9 instead of $12 (25% savings).
The ninth now paid $14 instead of $18 (22% savings).
The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before. And the first four continued to drink for free. But once outside the restaurant, the men began to compare their savings.

‘I only got a dollar out of the $20, ‘declared the e sixth man. He pointed to the tenth man, ‘but he got $10!’

‘Yeah, that’s right,’ exclaimed the fifth man. ‘I only saved a dollar, too.  It’s unfair that he got ten times more than I!’

‘That’s true!!’ shouted the seventh man. ‘Why should he get $10 back when I got only two? The wealthy get all the breaks!’*

‘Wait a minute,’ yelled the first four men in unison. ‘We didn’t get anything at all. The system exploits the poor!’

The nine men surrounded the tenth and beat him up.

The next night the tenth man didn’t show up for drinks, so the nine sat down and had beers without him. But when it came time to pay the bill, they discovered something important. They didn’t have enough money between all of them for even half of the bill!

And that, boys and girls, journalists and college professors, is how our tax system works. The people who pay the highest taxes get the most benefit from a tax reduction. Tax them too much, attack them for being wealthy, and they just may not show up anymore. In fact, they might start drinking overseas where the atmosphere is somewhat friendlier.

David R. Kamerschen, Ph.D.
Professor of Economics, University of Georgia
For those who understand, no explanation is needed.

For those who do not understand, no explanation is possible

Here’s how I responded:

I understand this example and also this that this is the point you are making about Obama’s campaign message.  The truth and risks inherent in the conclusion cannot be ignored — that if the system creates too many disincentives for work, savings and investment, entrepeneurs and wealth may flee.  But it is also an oversimplification.  Neither Buffett nor Gates needs to live in the U.S.  They didn’t inherit their wealth, but they still feel obliged to give back, to help others climb the economic ladder.  Where does that motivation fit into the bar story?  The ideal is to create lots of opportunities for everyone in the system, have a progressive system of taxation and work ceaselessly to inspire a belief in a national community and a commitment to the public good.

Please read Tom Friedman’s editorial in The New York Times today about “the Buffett effect!”

http://www.nytimes.com/2008/11/05/opinion/05friedman.html?ref=opinion

Reaching across the aisle, yet apt for this big election day!

Whatever America hopes to bring to pass in the

world must first come to pass in the

heart of America.

- Dwight D. Eisenhower