Self-Directed IRA Investing

The issue of how to value “hard to value” assets is now of concern to
regulators and those who are currently asked to make these assessments on
behalf of investors. Discussions are currently going on in the government,
because of the need to protect investors, particularly those who are
investing their retirement savings, from the surprises of Enron, Wordcom and
dot.bomb.

The difficulty of determining the “fair market value” or the “true market
value”, the current terms for the type of value determination to be
achieved, has also to be put into perspective. While the intent to apply
such standards is worthy (that is to protect investors from
surprises), actually doing so is an imperfect effort at best, and more an art
than a science. Whether you choose to determine value by selecting the last
price on a public stock sold in the public markets, or choose to spend
$40,000 to have an external valuation by a professional valuation company,
there is no pure method that can determine the actual value of any company,
public or private. The best one can accomplish is to derive an “approximate
value”. In choosing to use the price of a public stock (an “easier to
value” asset type), on a given day, you are inherently deciding that “price”
represents “value”. If that were truly the case, there wouldn’t be
discussion of “value” stocks, which are generally defined as stocks being
sold at less than the intrinsic value of the company they have a share of.
In some cases, such public stock is exchanged at less than the book value of
the company and far less than would be appropriate based on income, sales,
good will, competitive advantage, market trends, etc. It may just be that
an event such as September 11th or a jump in the price of oil, artificially
(that is, independent of the actual or perceived value of someone who would
perform an independent and in-depth valuation of the same company would
arrive at) signals and causes a drop in in the “price” of company’s stock.

So far then, one might accept the fact that fair market value based on price
is really an approximation of a company’s value based on the intersection of
supply and demand at a moment in time. And we all know from experience
that the price of a public stock can change dramatically within minutes and
seconds in the public market. Assume there is a sudden turn of events the
next morning when someone announces the discovery of 55 billion gallons of
oil in Arkansas, and the same stock that plummeted the day before sees a 15%
price increase, and the DOW rises 8%. Has the value of the company actually
changed? Maybe, and maybe not. When Enron sold on the NYSE the day before
it collapsed, was the price at which it sold a true representation of its
“fair market value”. Absolutely not, just as the fact that Arthur Andersen
stock prices on the same day did not represent the true “value” of its
stock. So selecting the price of a public stock as an estimate of value is
only arbitrary to the saver or investor, except, if they are liquidating
their investment at that price. At that point, “price” equals “value”,
because wealth transferred is equal to the price times the number of shares
of the asset in question. So much for the determination of value of a
“public” stock.

So what about the value of private companies and their stock? The formation
and funding of new businesses is essential to America’s economy and the
well-being of every citizen, isn’t it? I would think so since approximately
90% (approximately 23 million) of American businesses are non-public.
Shouldn’t the valuation be given the same level of attention as with public
companies. Certainly, but given the fact that there is not a convenient
yardstick like a public market to use to approximate value, different
approaches must be utilized. But, because a company, without earnings, in
the second year of its existence (and whose cost basis is based on the
founder’s stock purchased at pennies on the dollar) may be harder to value
with no stock conveniently being exchanged for a price on a public or
private market, does that make that company any less valuable than Enron one
month before its demise? Interesting question? Right. Well if that private
company turns out to be the next Google a year later, its stockholders may
be quite pleased in a $10,000 investment made at the ground floor that turns
into $500 million, despite the fact that no “true” fair market value could
have been practically determined a year earlier. So what’ is my point?
Simply that while there is a need to periodically assess the value of assets
held in retirement accounts for a variety of reasons, the processes by which
that can be accomplished are imperfect and that the choice between which
process and their associated costs, has to be evaluated against the benefits
to be derived, recognizing the results of all current methods will only be
approximations of “value”. The processes are the means and not the ends of
determining value, so that if a given process won’t get you any closer to
your goal, and costs you more in time and money, it probably shouldn’t be
applied. Because the benefit to the investor will not outweigh the cost.

So the question to be asked is why do we accept the price of a public stock
on a given day to be an acceptable representation of a company’s value. The
answer, I think is quite simple; that is, it is convenient, economical,
practical and timely way to get an approximation of what might be the value
of the company if someone did a thorough, expensive, and time consuming
analysis of the past, present, and future prospects of the company in
question. Of course, if such a full evaluation were practical to perform ,
you’d know the true market value. Wouldn’t you? Not really. If you ever
seen one of the evaluations which have to make assumptions about current and
future competition, regulatory, environmental, and demographic change,
quality of management and a myriad of other factors, they conclude with
several pages of caveats, which are just another way of saying that this is
the author’s best guess of the company’s value. They are not representative of
whether a “true” or “fair” market value but rather a value based on
assumptions about a company’s current strengths and its prospects. You can
spend $40,000 on a third party evaluation and not come necessarily any
closer to the “value” of any company. Presumably, Arthur Andersen charged
more than $40,000 for its services each year to essentially assess the
financial condition on Enron. No one in Arthur Andersen went to jail
accused and found guilty of deliberately distorting the facts. The company
died of essentially its inability to determine a true value because the
process is so difficult and complex in the real world. As the economy
becomes more global, the determination of “value” will not get any easier.
So what is one who is charged with the responsibility determine “fair market
value” to do to satisfy the underlying purpose of obtaining values of assets
held in retirement accounts; that is to serve the needs of investors relying
on estimates of value to help them determine whether and when they can
afford to retire? I would say it depends. That is that judgment has to
applied to an assessment of whether it is economically feasible in a given
circumstance to get closer than a reasonable approximation based on “best
efforts” (with information that is readily available) applied in a manner
that balances the extent of effort to further perfect a value (recognizing
like infinity one will never arrive there) with the cost benefit for doing
so.

On March 23^-24, I participated in the Wall Street Journal sponsored “Future of Finance Initiative” in Washington, D.C. Initially conceived to be a forum of financial experts to develop recommendations to the Obama Administration to help define the future of the financial system in this country (post the financial crisis), participants quickly modified the agenda to combine suggestions for dealing with the still occurring crises and the financial markets going forward. The results of the work of the 86 invited experts was published in the March 30^th Wall Street Journal. Prior to publication, the forum presented their recommendations in a White House briefing with Larry Summers, the President’s Assistant for Economic Policy and Director, National Economic Council.

While it was clear that time did not allow for the development of a comprehensive road map, the participants were able to reach consensus on 20 recommendations, many of which either echoed programs already underway or elaborated on them. This was no easy accomplishment considering the widely diverse points of view represented. In fact, one participant actually abstained from the voting on recommendations presumably out of protest. The wide-ranging group consisted of some of the titans of Wall Street, such as Arthur Levitt, former Head of the SEC; Paul Volcker, Chairman of the Economic Recovery Advisory Board; Gary Cohn, President of Goldman Sachs; and Damon Silvers, Associate General Counsel, AFL-CIO. Nevertheless, everyone checked their egos at the door and there were sincere efforts by all participants to take the challenge seriously and to try to help the nation’s financial system recover and progress in the future.

Personally, I found the experience to be the most intellectually and interesting in my 40 years in financial services and I was honored to be invited. More importantly, I hope that the result of the forum efforts will help the Administration with the vast array of issues needed to be resolved to stabilize the current economic crisis and to lay a foundation of controls and regulations that will prevent a reoccurrence in the future.

While it is not possible to recount all 20 recommendations in this newsletter, some interesting points can be shared. First, although many of the participants represented investment firms, banks, and broker/dealers as well as regulators of Wall Street, they were quick to suggest financial system improvements to reduce systemic risk that required more regulation of themselves. This objectivity was refreshing and appropriate and recommendations included:

• Improving disclosure, regulation and transparency from non-bank financial institutions, especially those involved in over-the-counter derivatives markets;

• The reform of rating agencies to eliminate the current environment of self-dealing and to compensate such agencies on their track record of success;

• Limiting the concentration of leverage across large systemically important financial institutions, through the use of capital and other controls;

• Developing a set of accounting rules that are pro-cyclical and to establish the Federal Reserve as the Systemic Risk Regulator of banking as well as non-bank financial institutions;

• Bolstering the FDIC with sufficient capital to ensure that all potential liabilities from bank failures are covered, and so that the public is reassured of the safety of their bank deposits;

• Allowing the Government to limit executive compensation in firms in which they and the public have a substantial economic interest;

• Strengthening the credit underwriting standards of financial institutions, and empowering and training regulators to enforce the standards;

• Streamlining the current regulatory architecture to make regulation more effective and consistent across all financial services industries and to eliminate regulatory arbitrage;

• Developing more effective and encompassing programs to limit and eventually forestall foreclosures such as more liberal and creative programs such as rent to own, principal reductions, loan modifications, for financially responsible Americans;

• Enhancing collateral requirements on over-the-counter derivatives and capital requirements for sponsors of credit default swaps; and

• Creating clearinghouses to enhance the transparency for standardized credit default swap contracts.

Since time did not allow for the development of the specifics guidelines, controls, and implementation plans for these and other suggestions, consideration is being given by the Wall Street Journal, forum participants and the Administration to continue the dialogue in the future. I hope to be invited to participate again and to lend my voice to the current concerns as well as my ideas to improve the ability of Americans to rebuild their retirement savings.

Surprisingly, there was no consensus on the inclusion of changing the mark-to-mark approach under FASB 157 for the evaluation of the securitized mortgage market, although there was heated debate over this issue. Following the event, however, I was glad to see the administration and FASB modify their position, and allowing banks t establish a value for these assets based on what they would be worth in an “orderly” market and not a “distressed” market. It is viewed by many, although diverging from the “free market” philosophy, that this nevertheless pragmatic change will allow banks to shore up their balance sheets, reduce their need for capital, and lead to the unlocking of credit markets. Unfortunately, however, as of this weekend, the government is still not acting on our recommendation to allow banks to return TARP money. Some 15 recipient banks desire to return all their TARP money, and they are willing to prepay all interest, but the government is refusing. The government’s position is not very clear, and we hope it will allow banks, that are capable, to return public funds in the very near future. Even more disturbing is the alleged coercion of one bank CEO who indicated to the media that even though his bank had no sub-prime mortgages nor derivatives, that he would see a public audit by the FDIC unless he agreed to take Government funds. That is scary, folks.

One remaining concern is the status of the derivatives markets. It is estimated that there are $186 trillion in bank derivatives. Continued decline in the strength of banks could force this market to freeze, a situation which could be disastrous. That’s why it is so important to strengthen the banks, so they are able to meet their obligations to each other.

Finally, I have to point out that there was no recommendation by the forum to put the G20 in the position of controlling the U.S. financial system. Our recommendation was to create a super regulator, like the Federal Reserve, to regulate all financial markets. I am pretty certain, that there would have been little support for what the Administration agreed to in the G20 meetings-that is, to allow member nations to have oversight of our markets. How or if this plays out will be an issue to reckon with.

Overall, I perceived a sincere sense of purpose and the recognition within the forum of the need for regulatory reform, refinement, and the application of ongoing sophisticated systemic science so that a similar crisis does not reoccur. I am personally proud of almost single-handedly championing the inclusion of foreclosure reform from the approximately 80 suggestions originally drafted, to the final twenty. I feel strongly that continued foreclosures will not only displace more Americans, but will continue to erode the value of the securitized mortgage market, exasperating the credit freeze, requiring more government intervention and deficit-financing and leading to more joblessness. While there is a consensus that not all Americans will be eligible for relief, I feel there is a need to stem the tide of foreclosures for responsible Americans, many of whom, were duped by fraudulent mortgage brokers. Besides, there is no upside when someone in foreclosed on. Both borrower and lender are adversely affected, as is the overall economy. Furthermore, the efforts of the committee that deal with the socio-economic aspects of the financial crisis, if acted upon, should help heal the current cleavage between Main Street and Wall Street, by providing a sense of order and control that will restore U.S. consumer and global confidence in the American financial system.

Tom W. Anderson, President and CEO of the PENSCO Trust Company has been invited by the Wall Street Journal’s Future of Finance Initiative, as one of a 100 national experts from the business community, to a working meeting in Washington to be held next week on March 23rd and 24th, that will develop and deliver recommendations to the Obama Administration on the future of banking and banking regulation. Following the working sessions, participants will meet with representatives of the administration and present the recommendations developed. The results of the working group’s efforts will also be published in the Wall Street Journal following the meeting. This is an exciting opportunity for PENSCO to play a leadership role by bringing retirement account issues, including the massive losses experienced over the past two years due to the lack of investment diversification, to the forefront of the Government’s attention. Anyone who would like to opine on the topic may email Mr. Anderson at tom.anderson@pensco.com.

On Saturday, March 7th, Tom Anderson, President and CEO of PENSCO Trust was awarded an Entrepreneurial Leadership Award for his efforts to advance entrepreneurship by Velocity (an MBA entrepreneurial educational program hosted by the University of California, Berkeley, Indiana University and Rice University. Mr. Anderson was a speaker at the forum and he discussed his experiences with the formation of is company, PENSCO Trust Company, as well as the nature of his business. The MBA students were surprisingly quite interested in the discussion about how IRAs have been used by entrepreneurs to fund thousands of small businesses in the U.S. This message was particularly well received due the current constraints in the traditional capital markets and the tightened credit situation in today’s economy. One student wrote that after returning to Los Angeles after the event, she found out at a cocktail party that one of her close friends was forming a bank through IRAs administered by PENSCO Trust!

For two days (March 5th and 6th), PENSCO Trust hosted a symposium where 10 expert speakers gave an audience of approximately 100 professionals a heavy dose of possibilities and opportunities created and supported by self-directed investing. One of the highlights was the testimonial by the two founders of PWAI whose business was started by IRA investors using PENSCO’s service. They were ecstatic that while other avenues in today’s capital markets were virtually non-existent or unavailable to them, they were able to attract the needed capital from the IRAs of friends, family and business associates. They are proceeding to get a patent on their new hair coloring technique and already their product and firm is attracting interest from some of the largest firms in the business. They are so happy they want to go on national TV to tell all Americans that their dreams for a new business can come through using self-directed IRAs. Who knows, maybe you’ll see their ad and product on a TV soon!