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September 24, 2008

Moral Hazard and the Aggregate Wealth Portfolio
by Mack Frankfurter

The largest financial bailout in United States history, which some traders are starting to call the 'Securitized Housing Investment Trust' (hint: think acronym), is causing an existential crisis amongst those who hold to purest free market ideology. Senator Jim Bunning, Republican of Kentucky, echoed this sentiment when he said, "The free market for all intents and purposes is dead in America." These ideologues doth protest too much, methinks.

Since the 1929 crash, the last time the nation faced an economic train-wreck of this magnitude, the U.S. Government has effectively been in the insurance business and it has generally served us well. The vast majority of laws and regulations are designed to mitigate risk. Drunk driving laws minimize the number of car wrecks, and the short uptick rule (until recently eliminated) prevented unfettered short-selling from forcing solvent companies into insolvency.

Government institutions enforce these policies. What is the purpose of the military but insurance against an attack from other nations? What is the key purpose of a central bank other than insurance against a run on banks?

In fact, the present-day capital market system, which has been responsible for raising living standards to the highest in world history, relies upon laws and regulations: the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act of 1936, and the Investment Advisers Act of 1940. Although not perfect (and definitely requiring an overhaul), these laws have served Wall Street and LaSalle Street very well over time.

The problem with fundamentalist free market ideology is that it is only theoretical, and ultimately not pragmatic. Truth is, without government establishing the premise of private property enforced through law and justice, contract markets would soon devolve and be quickly replaced by gangster capitalism akin to Putin's Russia. There is a term for the unfettered combination of concentrated power, ideological adherence and capitalistic greed, it is called "fascism."

There is another term "beta," which defines the systematic return/risk of assets. This concept is related to Modern Portfolio Theory and underlies the oft-stated investment strategy of buy-and-hold. What is not well-understood, even by many sophisticated investors, is that this theory is flawed. The issue is benchmark portfolio construction. Accordingly, the definition of "true beta" or "true market portfolio" must be extended to encompass other economic factors.

What academics came to recognize was that approximately one-third of non-governmental tangible assets in the U.S. are owned by the corporate sector, and only one-third of these corporate assets are financed by equity. As a result, Jagannathan and Wang concluded that assumptions underlying the concept of beta must be altered in order to resolve anomalies in the model. In other words, "true beta" or the "true market portfolio" must include the "aggregate wealth portfolio of all agents in the economy." This is a revolutionary view with both political and economic ramifications.

Business balance sheets do not in practice reflect public infrastructure assets which businesses are dependent on. For example, a trucking company's greatest asset is not its fleet of trucks, but the U.S. Highway system. Likewise, public liabilities such as the cost of pollution are also not reflected on corporate balance sheets. This is beginning to change with the idea of integrating regulations into "cap-and-trade" contract markets involving emission allowances.

It is time for a new economic ideology to take hold which adheres to a progressive view. Government and free enterprise are actually joint partners in promoting economic growth and well-being. Certainly, political will effects a constant tug-of-war between interests, but this is not unlike the struggle between a sales-trading desk which drive revenues for an investment bank, and internal compliance/risk managers who ensure balance between risk and reward.

The problem with the prevalent populist stream of conversation regarding free markets versus socialism is that such dialogue is anachronistic. Rather, the conversation needs to shift to good versus bad governance, and public policy which enhances the value of the aggregate wealth portfolio of all agents in the economy.

Michael "Mack" Frankfurter
Managing Director, Operations
Cervino Capital Management LLC

Every effort has been made to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete. There is no guarantee that the forecasts made, if any, will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. This material does not constitute a solicitation to invest in any program offered by any commodity trading advisor mentioned in the article including any program of Cervino Capital Management LLC which may only be made upon receipt of its Disclosure Document. Past performance is not necessarily indicative of future results. Investment involves risk. Investing in foreign markets involves currency and political risks. The risk of loss in trading commodities can be substantial.

Author's Background:
Michael "Mack" Frankfurter is a co-founder and Managing Director of Operations for Cervino Capital Management LLC, a commodity trading advisor and registered investment adviser based in Los Angeles, California. Mr. Frankfurter is also the Chief Investment Strategist and an Associated Person of Managed Account Research, Inc., an independent Introducing Broker focused on advising its clients in managed futures investments. In addition, he is a Managing Partner of NextStep Strategies, LLC which provides consulting services for companies in the financial industry. Occasionally, he pens articles as a freelance financial writer.