Category: Fraud

Great ideas do not often make for great investments

Growth investors like to talk about inventions and new ideas. The pull of growth investing is all you have to do is find a great company with a great product that will soon be big and you can just buy the stock and sit back for incredible gains. There are several problems with this thesis.

American Technology Company [[atco]] was the first stock that ever interested me. I was into high-fidelity music at the time and it was in an industry magazine that I first read about its technology to use multiple point sources of sound waves to project sound to a specific location (rather than all around).

If I had invested in ATCO 11 years ago and held until today, I would have lost over half my money.

ATCO 10Q

Graph.

Disclosure: No position in ATCO.

Lawyers Behaving Badly

Q: What’s the difference between a catfish and a lawyer?

A: One is a scum-sucking bottom feeder and the other is a fish.

I have recently made the acquaintance of a law firm that appears to use the above joke as its guiding principle. That firm is Friedman & Wexler. I recently got a new cell phone number and it just so happens to be the old phone number of someone who didn’t pay her bills. Friedman & Wexler has been playing the part of the collection agency and has been harassing me with automated phone calls to try to get me (actually, the former user of the phone number, Jasmin) to pay them. I sent them an email and asked them to stop harassing me and yet they keep calling me. Unlike with real collection agencies, no one comes on the phone if I pick up; the message simply says to call them. I am not about to waste my precious time trying to reach someone there and tell them that my name is not Jasmin and that I don’t owe their client money, so I’ll just ignore their calls for the next month and then I will get a new phone number with my shiny new 3G iPhone.

SEC Ensures that Penny Stock Market Manipulation Remains Profitable

An SEC enforcement division press release today shows why penny stock manipulation remains popular and why I hate the SEC. According to the SEC:

“The Commission’s complaint alleged that, in August and September 2002, Hayden, Marc Duchesne, and others carried out a scheme to manipulate the price of Nationwide’s stock. The scheme was orchestrated by Duchesne, and began with a matched trade between Duchesne and Hayden that artificially inflated Nationwide’s stock price from pennies to $9.35 per share. The Complaint further alleged that, thereafter, Duchesne, Hayden, and others bought or sold Nationwide shares at inflated prices to increase the price of Nationwide stock, to generate volume, and to stimulate market demand for the manipulated shares. The scheme collapsed on October 1, 2002, when the Commission suspended trading in Nationwide securities. “

The judge “entered a Final Judgment of permanent injunction and other relief, including a bar against participating in offerings of penny stocks, against Jeffrey A. Hayden on May 7, 2008.” Hayden agreed to the judgment “without admitting or denying the Commission’s allegations.”

Midway through reading the press release I thought to myself, “Hey, maybe the SEC finally is starting to care about penny stock manipulation!” The description of the financial penalty imposed upon Hayden destroyed any last shreds of hope I might have had that the SEC cares about doing its job (emphasis mine):

“Hayden was liable for disgorgement of $290,798, together with prejudgment interest of $116,330, but payment of these amounts was waived based upon Hayden’s sworn Statement of Financial Condition. A civil penalty was not imposed for the same reason.”

There you have it! The only penalty to Hayden was a promise not to manipulate penny stocks. He did not have to pay one penny. That is less than a slap on the wrist. This is yet another reason why I believe that we should abolish the SEC and most stock regulations and instead pursue stock market fraud under the common law definition of fraud. Penalties would be far harsher and might actually scare people away from penny stock manipulation.

(Note–I am not a lawyer; if you are one and I am spouting nonsense, please let me know!)

The Coming Mortgage Crisis Part III: Low Interest Rates Do Not Make Housing More Affordable

Many people have argued that the current high house price to income ratio is not reason for house prices to decline, considering that interest rates are very low now. These people argue that what is important is not the actual price of the house, but the mortgage payment required to carry the house (for an example see user jcrash’s comments on my previous aritcles on the coming mortgage crisis at SeekingAlpha).

To some extent, these arguments are correct. Most home buyers use mortgages, and the difference in monthly payments between a 5.5% and a 8% mortgage is staggering. However, there are two important reasons why low interest rates do not mean that houses are affordable now: household debt is at an all-time high and mortgage rates will certainly go higher.

Total Debt Matters

Housing affordability is not independent of the affordability of other consumer goods. What matters for the affordability of housing and all consumer goods is the money available to pay for those goods (ie, money not spent on necessities). Total household debt is at an all-time high. The savings rate is close to zero. The most instructive number to look at is the household financial obligation ratio, or the ratio of income to household debt servicing and house or apartment-related expenses. To quote the Federal Reserve definition, “Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. The financial obligations ratio (FOR) adds automobile lease payments, rental payments on tenant-occupied property, homeowners’ insurance, and property tax payments to the debt service ratio.”

Keep in mind that these ratios do not include other non-discretionary expenses such as food and gasoline, the price of both of which has been increasing at staggering rates, which means that consumers have less ability to service their debt than even the following graph shows (click for a full-sized image). The data are available from the Federal Reserve. The key number to look at is the FOR Homeowner Total (light blue). Over the last decade this has increased from about 15% of income to about 19% of income.

for.pngThese are the costs on debt and home-related expenses that current homeowners pay. Because these are broad averages (many homeowners do not have mortgages after paying them off, reducing these ratios), it is important to look at the change over time. The ratio is currently about 4 percentage points higher than anytime prior to 2000. While this may not seem like much, consider that house prices are set on the margin and that approximately 40% of homeowners do not have mortgages. The marginal home buyer has much larger debt payments of all kinds than ever before, reducing his ability to buy. This alone indicates that home prices need to fall. However, the picture gets even bleaker when we look at mortgage rates.

Inflation Matters

Those that argue that house prices are affordable would agree that lower interest rates make houses more affordable, ceteris parabus. This is true not just for houses but for all capital assets. As interest rates increase, asset prices decrease. As interest rates fall, asset prices rise. If a buyer finances a high-priced asset with cheap financing and does not sell when financing becomes expensive, that buyer will do fine. However, a buyer who cannot hold indefinitely must pay attention to asset prices. Even when payments are equal, it is better to buy a cheap asset with expensive financing than to buy an expensive asset with cheap financing. The reason is simple: interest rates change. Interest rates are more likely to fall when they are high than when they are low. If they do fall, the seller who had bought when interest rates were high will have a capital gain as the price of the asset increases. However, the seller who buys when interest rates are low will take a capital loss if he sells after rates rise.

Inflation in the US is at a 4% annual rate as of March, and investors expect inflation to continue or get worse, as evidenced by the low yields on TIPS (Treasury Inflation Protected Securities). With 15- and 30-year fixed rate prime mortgages near their lowest rates since before the 1960s/1970s inflation epidemic, there is little place for mortgage rates to go but up. Even if housing were fairly affordable now (which the FOR ratios above show that it is not), higher interest rates will ensure that it becomes less affordable and that house prices need to continue to drop.

See Also

Option ARMageddon take on this issue

The Coming Mortgage Crisis: Part 1
The Coming Mortgage Crisis: Part 2

Disclosure: I have significant real estate holdings and I plan on selling short one or more regional banks.

Auditors and the SEC Cannot Protect Investors from Fraud

There are many fools investors who believe that the SEC and auditors will actively prevent companies from engaging in financial statement fraud. These people are wrong, as shown by the SEC’s lawsuit against GlobeTel (OTC BB: GTEM), which at various points in time while the alleged fraud was taking place traded on the Pink Sheets, OTC Bulletin Board, and AMEX. Yet despite having audited financial statements, its auditors did not find the underlying alleged fraud. The SEC’s complaint (pdf) alleges

violations that span more than five years and include fraud and the unregistered sale of more than $l .6 million in stock. These violations involved one scheme to fraudulently inflate GlobeTel’s revenue and then hide millions of dollars in unpaid bills,and another scheme to sell GlobeTel stock in order to pay some of the
individuals who were responsible for the fraudulent inflation of GlobeTel’s revenue.

If you invest in a company, make sure you can trust management. While there are clues that a company may be cooking its books, dishonest management can fool even sophisticated investors for a long time (as Enron famously did).

Disclosure: I have no position in GTEM. I have a disclosure policy.

The dumb way to steal from your investors

If a manager who runs a $30 million hedge fund decides to embezzle money, it usually makes sense to actually embezzle it and then run away, rather than just transferring it to a shell-company brokerage account and then losing half of it selling short Treasuries. Evidently someone forgot to give that sage advice to Matthew La Madrid and his hedge fund management company Plus Money. According to a recent SEC complaint:

The complaint further alleges that, unbeknownst to investors, in the fall 2007 Plus Money and La Madrid abandoned the covered call trading strategy, emptied out the monies in the Premium Return Funds’ brokerage accounts, and dissipated the money through a series of illicit transfers.

The SEC’s complaint alleges that investors were not told that in the fall 2007, La Madrid and Plus Money transferred nearly all monies from the Premium Return Funds’ brokerage accounts to Vision Quest Investments, a La Madrid dba, which in turn transferred $10 million to relief defendant Palladium Holding Company. The complaint further alleges that Palladium:

* Transferred $5 million to its own brokerage account and used the funds to trade in numerous short-sell transactions involving Treasury bonds; as of April 25, this activity had depleted more than half of the account’s value
* Wired $500,000 back to La Madrid
* Transferred $1.8 million to several real estate title companies
* Used $95,000 towards the purchase of two automobiles
* Transferred another $90,000 to a Denver-based car dealership

What I do not understand is why La Madrid did not simply make the losing bets in the hedge fund. If he had lost the money in the fund then he would have been guilty of little more than misleading his investors about his investment strategy (the fund was supposed to invest in covered calls).

Background checks are a good thing

Penny stock Energytec (OTC BB: EYTC) had found a new CEO, Don Lambert, and things looked good. However, according to the SEC, Lambert “failed to disclose his prior federal securities fraud conviction, his multiple bankruptcies, and that he had forfeited his Texas law license to avoid being disbarred.” One would think a public company, even a tiny company traded OTC, would think to do a background check or a credit check. But they didn’t. Because the company’s SEC filings did not include this material information, the SEC went after Lambert and made him pay a $50,000 fine. He consented to the judgment “without admitting or denying the allegations.”

Disclosure: I have no position in EYTC.

The Coming Mortgage Crisis: Part II

Things are different this time. That is what I argued in my previous post on the coming mortgage crisis. Exploding option ARMs will lead to record foreclosures, which will cause house prices to further decline, which will cause many households to have negative equity. Rather than pay mortgages that are larger than house values, people will simply walk away.

One additional factor that will cause great harm to the housing market is that many stated income loans fraudulently overstated income ( I almost committed mortgage fraud myself). Bond insurers and buyers of RMBS and CDOs will force these back onto the balance sheets of investment banks and mortgage originators, leading to a further decrease in lending and an increase in lending standards. This will increase the cost of buying a house and put further downward pressure on house prices. The Market Ticker blog has a good discussion of this problem and the harm it will cause to banks.

Following are a couple more graphs to support my case that the bubble is nowhere near finished deflating. The first is the average house price to income ratio across the US, courtesy of PIMCO.

pimco.jpg

The second is a beautiful graph of home prices in every city in the Case/Shiller home price index. This comes courtesy of The Mess that Greenspan Made blog.

tim.png

You can see from this graph that home prices have a long way to go before they return to pre-bubble levels. Cleveland and Detroit are back to the 2000 price levels, but the fundamental deterioration in those cities means that prices should fall further. Detroit and Cleveland have had declining populations for a number of years, and that trend continues. It is predicted that Detroit will continue to lose population and have only 705,000 residents in 2035, down from 890,000 in 2005.

Disclosure: I own real estate in St. Louis and Chicago. I have a short position in a land development company. I have a full disclosure policy.

Research Frontiers Proxy Madness

Few companies can release a proxy statement to which stockholders react by dropping the company’s stock price by 15%. However, Research Frontiers [[refr]] does earn that dubious distinction. When I last wrote about Research Frontiers, the stock closed at $14.93. At a recent price of $5.19 per share, the stock is down over 64% since I called it a ‘failed company’.

While the proxy contains the standard stock options (including $900k to the chairman), stock appreciation rights, and other payments to executives, the interesting part is the company’s take on a shareholder proposal. The proposal reads in full (bold text mine):

 “RESOLUTION: Provide more detail information on film
production quantities and sales.

BE IT RESOLVED: On a quarterly basis beginning within 30
days of the 2008 annual meeting with the previous quarter’s
data, the company shall separately report revenue by license
fees and royalties; and report total royalty revenue that the
licensees are required to report by their license agreement
even though it might be below minimum royalty payments.
Additionally, the company shall provide information on how
much film is produced for sale as reported by licensees as
required by their license agreement. This information can be
aggregated for all licensees so that any individual licensee’s
information remains confidential.

Rationale for adoption: While there has been reported film
production and sales going back many years, there has not
been any officially reported measure of film produced or
revenue from sales that would inform shareholders of the true
extent of the commitment by licensees to develop SPD
products. In as much as the Company is 100% dependent on
licensees for SPD film production and sales, this information
equates to the viability of the Company and the only way to
fairly value the Company. Additionally, the Company has
over the years, partnered with licensees in the release of
information about SPD products for sale and sold but there
has been no information given to independently verify this.”

Unlike most shareholder proposals, this seems like a reasonable request for Research Frontiers to provide more detail on what its licensees are actually producing. The company’s reason to reject the proposal argues that the proposal would require giving out the licensees’ proprietary information, but the proposal clearly indicates that only aggregate disclosures would be necessary. More likely, the company wants to avoid disclosing that few if any actual products are being manufactured and shipped and all its revenues are coming from license fees and not from royalties on actual products.  Considering that in 2007 Research Frontiers reported $402,000 in revenue and yet boasts a large lists of licensees (see the 10k for details), I find it hard to believe that any of the licensees are shipping actual products and paying royalties.

More information:

2007 10K
2008 14A (Proxy Statement)

Disclosure: I have no position in REFR. I have never smoked reefer or coral reefs. I once took one puff on a cigarette but I did not inhale. I have a disclosure policy.

SEC: You can’t always trust press releases

In 2006, the investors in Southwestern Medical Solutions (then traded on the Pink Sheets) were informed via multiple press releases of the joyous news that the FDA had approved the company’s diagnostic tests. However, the SEC alleges that these were not true:

The complaint also alleges that Southwestern submitted false and misleading information about its business to the Pink Sheets, an inter-dealer electronic quotation and trading system in the over-the-counter securities market. The complaint further alleges Hedges, Powell, and Meecham were responsible in various capacities for preparing and disseminating the false press releases and false information provided to the Pink Sheets.

See the litigation release or the detailed complaint (pdf). If history is any guide, those individuals behind the company will only be forced to pay a small fine.