The Pope and Passover

I love ritual, which is why I felt great this whole week. Between the Pope’s arrival in the US and the advent of Passover, I’m feeling hopeful. I have been reflecting on the intersection of Pope Benedict XVI’s first papal visit to the US and the story of Passover to extract some lessons for us as we wade through the messy financial markets. I was struck how in both the Pope’s words and the story of Passover, there is an acceptance of the dualities of life: bad and good things occur and what gets us through is not just hope, but the knowledge that we will once again see better days.

Pope Benedict’s decision to address priestly sexual abuse as a central theme was courageous. He first raised the issue on his trip from Rome and did so again during an open Mass in Washington DC before nearly 50,000 people. Before you send an e-mail telling me that the Vatican was quiet for too long, let’s all agree on that point. But we are talking about the future here and the Pontiff chose to dredge up the worst part of the church’s dirty laundry and apologized by saying, “No words of mine could describe the pain and harm inflicted by such abuse…It is important that those who have suffered be given loving pastoral attention.”

I know that this is a stretch, but wouldn’t we applaud if CEOs, regulators (including Federal Reserve Governors, past and present) and everyone in the financial services industry took a similar path? It would be great if all participants could admit the role that they played, not by pining mistakes on anything other than some of the most basic human emotions: greed and overconfidence.

The story of Passover also confronts the best and worse that humans have to offer, telling the story of the Jewish enslavement in Egypt and the eventual freedom over the course of a meal, called a “Seder”. The holiday is celebrated by retelling the story, acknowledging all of the bitter hardships that occurred and the sweetness of freedom that finally occurred. One of the more interesting parts of the holiday is that it calls on Jews to remember not only what happened to Jews, but tragedies of slavery that occur even today.

It may seem trivial to compare economic worries or investment concerns to issues of abuse or slavery, but how we navigate treacherous times can so often define who we are. We are all afflicted by the condition of being humans: good, bad, greedy, and fearful – and all of the other dualities that we face. Having faith and knowledge can help us get to those better days with a bit more grace and less anxiety.

They’re Just Like Us!

One of my favorite indulgences is to pick up a copy of US Weekly and read the segment called “They’re Just Like Us!” In it, paparazzi snap celebrities doing ordinary things—look, there’s Meg Ryan eating lunch; Madonna running in Central Park; and Drew Barrymore grocery shopping. I thought of the feature after reading two articles about Merrill Lynch: one in the April 16th edition of the Wall Street Journal (Merrill Upped Ante as Boom In Mortgage Bonds Fizzled by Susan Pulliam, Serena Ng and Randall Smith) and the other about Merrill’s former CEO, Stan O’Neal in the March 31, 2008 edition of The New Yorker (by John Cassidy).

The New Yorker article took an in-depth look at O’Neal, but what made me think “they’re just like us” is the description of how an obviously smart guy could be seduced by the outsized returns of a complicated asset—in this case it was collateralized debt obligations. I can not count the number of times that people come in and talk to us about opaque strategies or products that they don’t really understand. “I really don’t know what it is, but I made money.” If that happens, my advice is to get out while the getting is good!

In the Journal article, it is noted that Merrill made easy money early in the housing boom. Again, “they’re just like us!” If you bought technology stocks in the mid-nineties or participated in IPOs (which you never really understood), you probably made a bunch of money. But as a good idea matures and ultimately morphs into a boom or mania, things can get dicier. The risk ratchets even higher and you may think to yourself, “I’ll be all right—I’ll know when to get out.”

That’s kind of what happened at Merrill. According to the Journal, “By early 2007, as cracks in the housing and mortgage markets widened, Merrill again missed a chance to scale back. In fact, it revved up its production of complex debt securities -- despite a shortage of buyers for them -- in what turned out to be a misguided effort to limit its losses…Instead of scaling back its underwriting of CDOs, however, Merrill put the business in overdrive. It began holding on its own books large chunks of the highest-rated parts of CDOs whose risk it couldn't offload.”

They really are like us-tempted by big returns, investors as big as Merrill and as small as you, can get sloppy and disregard risks that exist. The behavior usually does not change until the market extracts its pound of flesh for these mistakes. In Merrill’s case, we’ll find out whether the bleeding has stopped when it reports its quarterly results today.

The Biggest Loser

I usually do not like reality television shows, but NBC’s “The Biggest Loser” is different. From the first episode, I was drawn in to the program that requires overweight contestants to challenge themselves before America to try to lose weight. Everyone wants to claim the $250,000 prize but it is clear that each one is on the program to reclaim his or her life. As I watched the finale last night, I knew that there were lessons for investors to learn from these “Biggest Losers”.

The first thing that is striking when the twenty participants show up is the moment they step on the scale. For some, it has been years since they actually knew their weight. This is not unlike many meetings that I conduct, when people, even those who have a lot of money, admit that they have no idea what they own inside their accounts. One woman with $1.5 million noted, “it’s almost like I am afraid to look because then I would have to be responsible for dealing with it.” It is clear that both in weight loss and investing, it is important to know where you stand.

After seeing the numbers, most of the Biggest Losers were shocked, but they were lucky enough to have one of two trainers assigned to them. The trainers are responsible for developing and implementing a diet and exercise program that would help each contestant reach a predetermined goal. Obviously not every person who is overweight has the luxury, but it’s TV! I love the idea of setting goals and creating a plan to reach them. Recently a woman said to me, “I am nearing 60 and all I want to do is make sure that when I stop working in few years, my money will provide me with $70,000 per year. I’m just not sure how to get there with my investment portfolio.” That is a specific goal, which is great and all I had to do as the “trainer” was to create the game plan.

The next steps include hard work and discipline. I wish it were easier, but it isn’t. Watching each participant struggle with the workouts and re-learn how to eat, I thought about how investors often have to endure pain (see 2000-2002 and more recently, the first quarter of this year!) and battle old demons. How often are there moments during a downturn when you want to act emotionally and simply sell? Like reaching for that bad food choice, it is hard not to succumb to emotions, but disciplined investors know that sticking to the plan is likely to get them closer to the goal.

Measuring performance is imperative to understanding how you are doing and knowing whether you need to make adjustments along the way. If you are trying to lose weight, you need to step on the scale and face the numbers (on the show, this occurred weekly and was the high point for the contestants and viewers.) If you are managing your portfolios or if you have hired someone to do it for you, you need to know your performance and compare it to the most relevant benchmark. Investors should do this at least quarterly.

Finally, I should note that just because you fall off track does not mean you can’t get back on and be successful. The winner of Biggest Loser was Ali, a 32-year old woman who was voted off the show after the third week, only to win a spot back on five weeks later. She went home, stuck to the plan, got back on the show and ultimately lost the highest percentage of weight of the twenty contestants. She reached her goal, won the $250,000 prize and now must maintain all of the amazing progress that she has made. I would tell Ali what I tell many of my clients: you have done all of the hard work, so now its time to not screw up! Stay on plan, be disciplined and stay in control. By doing so, the Biggest Loser can continue to be the biggest winner.

Down to the Wire

Today is Uncle Sam’s favorite day of the year: the tax filing deadline. If you are a procrastinator, keep reading on. If you have mailed off your returns, read on to feel better about what good person you are!

Let’s start with a fact: the IRS hates tardiness. The penalty for late filing is 5% per month up to a maximum of 25% of the amount of tax due on the late-filed return. That’s why you have to get busy! One way to do so is to file an extension (Form 4868), which allows an additional six months to complete your return. Even with an extension, you must pay what you estimate you might owe. The IRS not only detests late filers, but late payers do not do much better---the penalty for late payers is one-half of 1% per month up to a maximum of 25% of the amount of tax due on the return.

If you do not have the money to pay right now, one option is to request an installment agreement with the IRS. If you owe less than $25,000, you can pay what you can now and then attach Form 9465 (Installment Agreement Request) on the front of your tax return. You should also include a statement explaining why you can’t pay the full amount due. The IRS charges a user fee for establishing an installment agreement, which can be as high as $105 ($52 if payments are automatically deducted from your bank account). You have up to five years to pay and you will also have to pay interest and penalties due until the agreement is paid off, unless the IRS agrees to lower the interest rate as part of the installment plan. Additionally, you are required to pay all future taxes in full and on time. Once you file, do not assume that you are done---the IRS will contact you with the terms of the installment plan.

If you are short on cash, another option is to charge your taxes on your credit card, which will cost you an extra 2.49% processing fee. While I hate to suggest this, in the current low interest environment, it is possible that the interest from your credit card company is lower than that of the IRS.

If you are filing your returns and do not need an extension or an installment plan, be sure to review the following before sealing the envelope or pushing send:

-Correct Social Security #s for all individuals listed on your return
-Sign and date returns – make sure that spouses sign too!
-Attach all W-2 and other forms required – spot check that W-2 forms line up with what you have reported on the return
-Take IRA deductions if you have funded them or fund them if you took them

TIPS FOR NEXT YEAR:

· Adjust your withholding. Your circumstances and the tax law change constantly and so does your tax liability. To make sure that you are not lending Uncle Sam money interest-free, you may need to adjust your withholding with your employer. Conversely, if you had an unpleasant surprise and actually had to pay Uncle, you may need to withhold more money. Adjusting your withholding now is a good way to even out your cash flow throughout the year.

· Make retirement contributions early. Did you receive a tax refund? Instead of spending it, why not plow it into your Roth or Traditional IRA? Get that money working before you spend it!

· If you are self-employed or own your own business, talk to your CPA now in order to determine the best retirement plan vehicle for you.

· Review your benefits at work. Can you put a little more into your retirement plan? Can you pay for certain benefits with tax-free dollars? Try to reduce your out of pocket costs by utilizing your company’s benefits plan more wisely.

· Submit medical and dependent care account expenses quarterly. Many tax filers mistakenly believe that they can deduct expenses up to tax filing time. Unfortunately, you must claim these expenses in the calendar year, or else you will lose the money you set aside to pay for them. The key here is to claim as you go.

· Consider converting “bad debt”, like credit cards or car loans into “good debt”, like a mortgage, or home equity loan. This used to be a slam dunk recommendation, but with the credit crisis, it’s harder to qualify, but check if this might make sense for you.

· If you expect a windfall this year, set aside the tax money in a safe, low risk instrument. Do not invest the money in a hot tip or even what you consider a safe mutual fund.

· Start a file for next year’s tax information right now.

“Phew, I’m glad that’s over!”

Often the payback for a rotten economy/market is the much-needed recovery. Like the respite after a grueling workout, investors can quickly forget the pain with a healthy portfolio gain. Considering that the S&P 500 fell 9.9% in the first quarter of this year, the worst initial three months of any calendar year since 2001, many are hopeful that April’s rebound from the March lows is the beginning of the “Phew, I’m glad that’s over” period.

You may remember this feeling from the last time we were in a similar, though not nearly as bad a place. After three years of losses from 2000-2002, where the S&P 500 fell almost 50%, there was a collective sigh of relief in 2003 when the index rebounded 26.4%. Of course if your portfolio went from $1 million in 2000 to $500K at the end of 2002 and then to $632K at the end of 2003, you still may not be very happy, but investors tended to write off the three years and concentrated on the good year.

So how do the prospects for the coming recovery look? Unfortunately, because of how we got to this place, the “Phew, I’m glad that’s over” period may be weaker than those in the past. The reason can be summed up with one word: leverage, or the degree to which an individual, investor or business utilizes borrowed money. The easiest area to see this is in housing, where homebuyers were able to purchase homes with little or none of their own money, magnifying profits on the way up and eventually, losses on the way down.

In the investment banking world, leverage led to the collapse of Bear Stearns, which had borrowed over $30 dollars for each dollar that was invested. The other major US banks--Lehman Brothers, Morgan Stanley, Merrill Lynch and Goldman Sachs--were not far behind those levels. Compounding the problem, these banks lent to other entities (i.e. hedge funds) that were also leveraged. When borrowed money is financing transactions, it only takes small moves down to wipe you out.

This eventually leads to a cleansing—a de-leveraging period where participants literally pay-down their debts. As anyone who has ever tried to erase a nasty debt knows, the process can be a lengthy one. For that reason, a long period of slower-than-normal recovery may lie ahead. In addition to deleveraging, the Bernanke Fed is likely to raise rates to combat inflation, which will probably accelerate as the disinflationary benefits of globalization recede. That could mean that the “Phew, I’m glad that’s over” period may be when the pain ends, but the upside is not quite as robust.