Saturday, March 15, 2008

Random Musing On The Real ID Act (a.k.a. the National ID Card)

Notice: The Random Musing is meant to amuse, pique curiosity, and add a bit of controversy by looking at issue from a completely different perspective. If you emote after reading the Random Musing, then it is working.

Rather than trying to get everyone on-board on using a national ID card as required by Department of Homeland Security (DHS) and causing major headache for all states with the Real ID Act, isn’t there a better solution?

As a risk manager, I believe that operational efficiency and effectiveness goes hand in hand with reducing risks to any organization. So, in that frame of mind, I present the following alternative:

A Federal Government Travel ID that is only required to travel on planes or to access a Federal facility.

Here are the benefits of a Federal Government Travel ID:

1. Centralized control – DHS has to love this
2. Uniformity – Why leave it to the states to re-design their driver’s license and non-driver identification card? Having one format will reduce training time and cost since TSA agents will have to study and recognize only one ID format rather than all 50.
3. Will allow seamless access to the holder of such Travel ID to all Federal facilities that are open to the public.
4. Lower Cost – All the state governors will thank the DHS for giving them a way out of spending millions of dollars to upgrade their computer systems to comply with the Real ID Act.
5. Public Support – I think people would not mind having the option of not getting a travel ID, if they don’t like the idea. It will also save them money and time, as they would not have to go in person to renew their licenses or identification card.

Isn’t this wonderful? All of the benefits that the Real ID Act provides with low or no cost to comply.

Am I just dreaming or whistling Dixie? Nope. The last time I checked, we already have a centralized Federal Travel ID that has your picture and all ten fingerprints.

It is called the U.S. PASSPORT.

Wow! What a wonderful concept. Isn’t that what a passport was invented for? To travel? Well, if the public is already accustomed to getting their picture taken, fingerprinted, filling out forms with their most personal data, and then having to go to a local passport office, wait a few hours, and pay $100 for a passport, why mess with a system that people already uses?

Remember, traveling on an airplane, like driving, is a privilege that we pay for. And as such, we will need to comply with the rules, no matter how absurd we think the rules are.

So, if you are upset at the security screening procedure at the airports, then understand that other are too. Therefore, rather than grinning it and bearing it, let your congress representative know just how you feel. That's the correct way to exercise our rights under the 1st amendment.

Ed Kim

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Friday, March 14, 2008

Bear Sterns: Soon To Be a Part of JPMorgan

The newspapers today are all a buzz about Bear Stern’s liquidity crunch and the concerted efforts that the JPMorgan and the Fed are taking to provide some immediate relief. The New York Times reports that [bold and italics added for emphasis]:

“For the next month, JPMorgan will work with Bear Stearns to reach a solution for its financing crisis. Options could include organizing permanent financing or, according to people briefed on the discussions, buying the bank for a discounted price.

Isn’t it ironic that Bear Sterns, which had refused to go along with other Wall Street firms to save Long Term Capital Management (LTCM) in 1998, is now faced with the same problem? However, Jamie Dimon, the CEO of JPMorgan is a shrewd banker who will not let that bit of history get in the way of getting Bear Sterns at a very discounted price.

JPMorgan’s Bear Hug

While JPMorgan has repeatedly publicly stated that it is not in the market for an investment bank, Bear Sterns makes a very good case from a risk / reward basis. Given the near collapse of the Bear Stern’s stock price, the market cap of Bear Sterns is approximately $4.4 billion, as of midday Friday, March 14, 2008. Given JPMorgan’s strong capital position – $88.7 billion in reserve (resulting in an approximately 8.1% Tier 1 capital ratio and approximately 12.6% capital ration, overall) and $71.9 billion in tangible common equity, at the end of 2007.

Given the strength of their financial statements, JPMorgan can easily absorb Bear Sterns without substantially denting their capital.

Additionally, Bear Sterns is not a true investment bank as it historically dealt heavily in mortgage back securities and did not diversify out of this niche. Additionally, Bear has valuable business units, such as its real estate, hedge fund servicing, and strong back office units.

Why It Makes Sense

Since Bear Sterns was really a mortgage back securities trading firm rather than a full service investment bank, Bear’s mortgage-back securities and mortgage trading business will help to boost JPMorgan’s standing in the global debt capital league market.

According to Thomson Financial global mortgage-backed securities league table (B10), for FY 2007, JPMorgan at $77.9 billion was ranked 6th and Bear at $86.5 billion was ranked 3rd. If combined, JPMorgan would move to the top at $164.4 billion, displacing Lehman Brother at $115.8 billion.

Additionally, Bear Sterns has one of the best back office units in the business. The market for debt securities will improve. By using this period of uncertainty and slow business, JPMorgan has the time to combine the two back offices together and be prepared to take larger share of the settlement business when the market returns.

Finally, I think the Bear’s office, which is located directly across the street from JPMorgan’s headquarters at 270 Park Avenue, provides easy logistical integration. I hope Jamie takes this opportunity to takeover Bear Sterns.

Go Jamie!

Ed Kim

DISCLOSURE: The author holds long positions in JPM at this time.

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Thursday, March 13, 2008

Federal Government To Revamp Credit Rules: Good Intent, Bad Execution

The Wall Street Journal reported today that the U.S. government would release a broad blueprint for preventing a re-occurrence of the current credit crisis:

“Mr. Paulson told The Wall Street Journal that the recommendations of the President's Working Group on Financial Markets, which he leads, include strengthening state and federal oversight of mortgage lenders and brokers. The group will also recommend implementing what he termed "strong nationwide licensing standards" for mortgage brokers, a move that will probably require legislation.

The group also will propose directing credit-rating firms and regulators to differentiate between ratings on complex structured products and conventional bonds. In addition, it wants rating firms to disclose conflicts of interest and details of their reviews and to heighten scrutiny of outfits that originate loans that are enveloped by various securities.

Another recommendation from the panel is to push issuers of mortgage-backed securities to disclose more about "the level and scope of due diligence" and about the underlying assets of the securities. The panel is also seeking disclosure of whether "issuers have shopped for ratings" -- that is, have had to go to more than one credit-rating firm before getting the triple-A stamp of approval.

And the panel will urge global bank regulators to revisit the latest version of bank capital requirements, known as Basel II for the Swiss city where they were negotiated, so that banks that take on risks hold sufficient capital. The panel also wants regulators to complete updated standards for how banks manage liquidity.”

While the intentions are good, it appears that the execution of these good intentions is going to be done badly. The attempt by Henry Paulson and Co. are well intended but the draft of what they are proposing raises far more question about how the revised oversight will work and what will be done about the existing regulations.

Strengthening State And Federal Oversight Of Lenders And Brokers:
Currently, each State maintains oversight of mortgage brokers. While the States oversights lack uniformity, to enforce a national standard would risk infringing on the State’s rights to self-govern. Moreover, there is a high probability of risk that the national standards would be a very watered down, compromised legislation that may not address the core issue of preventing unscrupulous broker and/or lending activities.

As for the oversight of the lenders, we already have an interagency governmental body, the FFIEC, which is charged with ensuring uniformity of bank examination between FDIC, OCC, FRB, OTS, and NCUA. Moreover, FFIEC has an advisory State Liaison Committee that is composed of five representatives of state supervisory agencies. So, as for the strengthening of the federal oversight, what is the working group proposing that the FFIEC cannot currently do?

Separate Rating Standards For Complex and Conventional Bonds:
Who determines what is complex and conventional bonds? What happens if a bond structure contains only different AAA rated traunches of various municipal bonds?

Would this bond be considered to be a complex bond when it only consists of AAA municipal bond traunches?

Are we increasing the risk of creating a confusing array of ratings that may lead to investors comparing ‘Apples to Oranges’?

Potentially, we could have a situation where the AAA rating of a conventional bond is a better credit than the AAA rating of a Complex bond.

Who gets the asterisk next to their AAA rating?

Who will ensure that the rating agencies will apply uniform rating standards for new issues as well as re-rating of existing issues? There is also a knock-on risk to the bond insurance business.

Rating Firms To Disclose Conflicts Of Interest And Details Of Their Reviews:
How will the regulators monitor what is appropriate disclosure or insufficient disclosure?

How will the regulators determine if there is a conflict of interest of insufficient details of review?

Does this mean that the regulators will have to review and approve the actions of the rating agencies prior to the rating agency publishing their rating? How will that work?

If the regulators determine that the disclosures and details are insufficient or improper, does this mean that the rating is invalid?

Are we adding a risk that the regulators will be asked to rate the rating agency?

Currently, the rating agencies are paid by the issuers to rate their proposed transaction. If this process remains the same, then every rating will have a standard conflict of interest language embedded in their rating. So, if that is the likely outcome, then what really is the benefit? After all, the current disclosure by the rating agencies include conflict of interest and other disclaimers:

Moody’s disclaimer:
“NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding or selling.

MOODY’S hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODY’S have, prior to assignment of any rating, agreed to pay to MOODY’S for appraisal and rating services rendered by it fees ranging from $1,500 to approximately $2,400,000.”

S&P disclaimer:
“Analytic services provided by Standard & Poor's Ratings Services (Ratings Services) are the result of separate activities designed to preserve the independence and objectivity of ratings opinions. The credit ratings and observations contained herein are solely statements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make any other investment decisions. Accordingly, any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision. Ratings are based on information received by Ratings Services. Other divisions of Standard & Poor's may have information that is not available to Ratings Services. Standard & Poor's has established policies and procedures to maintain the confidentiality of non-public information received during the ratings process.

Ratings Services receives compensation for its ratings. Such compensation is normally paid either by the issuers of such securities or third parties participating in marketing the securities. While Standard & Poor's reserves the right to disseminate the rating, it receives no payment for doing so, except for subscriptions to its publications. Additional information about our ratings fees is available at”

Lastly, this basically seems to be a repeat of the Investment Company Institute’s 2002 request to SEC on rating agency, which recommended that:

“the Commission [SEC] consider adopting the following regulatory improvements:

§ a new regime of vigorous and continuing Commission oversight of the credit rating agencies;

§ public disclosure of the resources, standards, procedures, and policies employed by the agencies in their rating process;

§ a new public comment and review process regarding the agencies' performance, standards, and methodologies; and

§ legal accountability.”

Heighten Scrutiny Of Outfits That Originate Loans That Are Enveloped By Various Securities:

What type of heighten scrutiny is the working group seeking to accomplish that the SEC, OCC, FDIC, and other regulatory bodies currently not performing?

Isn’t this a backhanded slap at the regulatory bodies for not doing their jobs properly?

Are we at risk of creating an additional layer of regulatory framework that may hinder the existing one?

Issuers Of MBS To Disclose More About "The Level And Scope Of Due Diligence" And Underlying Assets:
How much more disclosure is required and how is that disclosure going to prevent a similar crisis? Isn’t the Prospectus already providing the level of disclosure and detail required? Isn’t this what Regulation FD is supposed to provide?

Disclosure Of Whether "Issuers Have Shopped For Ratings":
Again, how is this disclosure going to prevent a similar crisis?

Typically on a MBS transaction, at least two of the three rating agencies rate the transaction. Most times, all three rating agencies rate the transaction. If the issuer did shop around, given the very finite number of rating agencies that investors typically look for – S&P, Moody’s, and Fitch Ratings – there really isn’t much this disclosure will do to help the investors.

Urge Global Bank Regulators To Revisit The Latest Version Of Bank Capital Requirements:
The Basel II framework already stipulates the methodology for calculating reserves using a risk-based approach. The reason the banks did not hold sufficient reserves in the first place was the ability of the banks to take the loans off their balance sheet via securitization. There is no need to revise the Basel II capital requirement. Rather, prevent offloading of loans from banks balance sheet, which will then force the banks to include the loans into their capital reserve requirement calculation.

In conclusion, I would have hoped to read that the Federal government would at least allow the market to take its natural course in the current credit crunch. However, it is very clear that the government is taking a heavy-handed approach to save financial institutions that made large bets on MBS and credit derivatives and are now losing their shirts. I wonder if the Federal Government would have done the same if Enron was a brokerage house.

Ed Kim

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Risk Of Rising Fuel Cost To The Airline Companies

With the fuel cost continuing to rise, the airline companies (such as Continential, Delta, American, Northwest, United, US Air, Southwest, JetBlue, etc) are again facing the possibility of entering Bankruptcy protection. According to the Air Transport Association, the fuel cost went from 10.5% of total operating expenses in 2001 to 24.4% in 2006 (as of 3Q 2007, this had increased to 26.5%). During the same period, the Passenger Unit Revenue (calculated at cents per Available Seat Miles, or ASM) increased 15.6% from 8.7 cents in 2001 to 10.06 cents in 2006[i]. Most of the revenue increase over this period could be explained by increased load factor (a full plane equals 100%), which went from 70% from 2001 to 79.2% in 2006. (This explains why the planes are now pretty much full.)

Additionally, airline companies have improved passenger airline fuel efficiency 36%, on average, and improved combined passenger and cargo airline fuel efficiency 24% from 2000 to 1st half of 2007[ii].

Even with the improvements in passenger and cargo airline fuel efficiency and higher load factors, the airline industry’s operating expenses in 2006 was 95.4% of operating income, resulting in a very thin 4.6% operating profit. With increasing fuel costs, this slim operating profit will be wiped out.

While the airline companies have done a tremendous job of improving their load factor and passenger and cargo airline fuel efficiency, the projection of higher fuel costs, leaves the airline companies with few options for staying in business.

Can The Airline Companies Survive?
In order for the airline companies to survive, they have to increase revenue sufficiently to overcome the increased expenses or to reduce operating costs further. Since fuel cost is the largest component of operating expenses, the focus of the airline industry, naturally, is firmly on ways to improve fuel efficiency.

Some of the steps proposed by the airline industry are[iii]:

· optimize flight planning for minimum fuel-burn routes and altitudes
· work with FAA to change en-route fuel reserve requirements to reflect state-of-the-art navigation, communication, surveillance and wind forecast systems
· employ self-imposed ground delays to reduce airborne holding
· modernize their fleets with more fuel-efficient airplanes
· invest in winglets to reduce aircraft drag and thereby increase fuel conservation
· redesign hubs and schedules to alleviate congestion
· advocate expanded and improved airfield capacity
· use airport power rather than onboard auxiliary power units (APUs) when at the gates
· change paint schemes to minimize heat absorption (which requires additional cooling)
· alter the location in which fuel is purchased (i.e., to avoid higher-priced west coast)
· pool resources to purchase fuel in bulk through alliances with other carriers

What Else Can The Airline Industry Do?
With all their fixation on improving fuel efficiency and cutting cost, there is one area that the airline industry doesn’t like to talk about: raising airfares.

While prices of goods and services in the U.S. has increased 3.1 times, based on CPI increase from 1978 to 2006, the price of air travel has only increased by 1.5 times, for domestic flights:

Click to enlarge

*Congress enacted legislation deregulating domestic airline passenger service in October 1978.
1. The College Board – based on beginning of academic year
2. U.S. Bureau of Labor Statistics – includes hedonic “quality-change” adjustments
3. U.S. Census Bureau – median value
4. ATA via U.S. Bureau of Transportation Statistics – excludes taxes
5. U.S. Postal Service – Publication 100
6. National Automobile Dealers Association – average retail selling price
7. U.S. Department of Energy – Monthly Energy Report, Table 9.4
8. National Association of Theatre Owners

Risks of Increasing Airfare:

§ Potential passengers, particularly the casual travelers, may switch to alternative form of transportation, leading to lower load factor.

§ Other air carriers, particularly the low cost air carriers, may not match the increased fare, leading to travelers switching to a lower cost carrier.

Any Other Options? – Thinking Outside The Box

§ Airline companies can begin charging for checked luggage. Since it cost approximately 5 cents to fly one pound 1,000 miles, any extra weight will burn extra fuel.

§ Begin charging by total weight. Air taxis that serve the remote regions of Alaska charge a flat rate up to a specified weight limit per person, typically 250 pounds. Anything more than this will either get left behind or will incur additional cost[iv]. It makes no economic sense to charge the same fare to a large person who brings on an overstuffed carry-on bag and a 10-year old child. Industry experts will tell you that additional weight costs the airline industry millions of dollars.

§ Reduce power-up cost by using aircraft tow tractors to tow the plane to the end of the runway before powering up the Jet. This might be too radical but a risk manger sometimes has to think outside the box. The aircraft two tractors can easily tow a B747 while burning far less fuel than the B747 would, going from the terminal to the runway. Oftentimes, the time from terminal to runway can take more than 30 minutes due to traffic. All this while, the airplane is burning tremendous amount of fuel, just idling.

There are risks to bold thinking but for the airline industries to survive, bold thinking will be necessary. The staid ideas of cutting service to reduce costs are not working. Moreover, there are very few remaining service items to cut. Therefore, the industry needs to think of ways to generate more revenue, and fast.

Ed Kim

DISCLOSURE: The author holds no long or short positions in Airline Companies at this time.

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Wednesday, March 12, 2008

Risk of Mr. Bush’s Continued Pursuit Of A Failed Middle East Policy

Bloomberg reported today on Mr. Bush’s effort to freeze the assets of an Iran-Linked Bahrain Bank:

“The Bush administration will freeze any U.S. assets of Future Bank B.S.C., a Bahrain-based bank controlled by an Iranian lender linked to Iran's pursuit of nuclear weapons, the Treasury Department said in a statement.”

To paraphrase former President Regan: “Here he goes again.”

After years of implementing his unilateral ‘shoot first and ask questions later’ form of foreign policy in Iraq, Mr. Bush is, once again, trying to build a case for a war with Iran. I guess Mr. Bush doesn’t like diplomatic approach to foreign policy.

Risks Arising From A War With Iran (May It Not Happen)

Risk of Our Military Structure Breaking Down: Our military resources are already overstretched with its war in Iraq and Afghanistan and risk. According to MSNBC report, the military may be at a breaking point. If this occurs, our national defense may be vulnerable to attack since 40% of the national guard troops, the very soldier we rely on for national defense, are deployed in Iraq and Afghanistan.

Risk of Substantially Increasing Our National Deficit: We have spent more than $510 billion in the Iraq War and the cost of the Iraq War, according to MSNBC, running at $200 million a day may top $1 trillion. A more recent Washington Post report indicates that the cost may top $1.3 trillion. Our FY 2008 national budget is $3 trillion. So, the total cost of the Iraq War is 1/3 the total U.S. budget for 2008. If we persist in pursuing a foolhardy war with Iran, then the cost to the U.S. could exceed $3 trillion. In fact, Paul Farrell of Market Watch estimated that a war with Iran would cost $32,000 per American, or $9.6 trillion, based on U.S. population of 300 million.

Risk of Severe American Casualties: No one is willing to estimate number of U.S. casualties should we go to war with Iran. However, with more than 168,000 troops on the ground in Iraq and Afghanistan, it is highly probable that any attack on Iran will result in increased terrorist attacks to our ground forces. Moreover, it is not unlikely that Iran may employ wholesale suicide-like ground attack by the Revolutionary Guards, similar to the attacks employed during the Iraq-Iran war, on our troops in Iraq, causing tens of thousands of American casualties.

Macroeconomic Risks: Econbrowser, a blog about economic condition and policy has a very detailed analysis about the macroeconomic risks of going to war with Iran. The immediate implication is the price of oil skyrocketing up, perhaps as high as $250 per barrel, as the flow of up to 20% of the regions oil supply is curtailed due to Iranian attacks on shipping lanes and as Iran cuts off supply of its own oil to the west. Overall, the GDP of western countries may see a drop of 1%.

Risk of Increased Internal Security Costs: As a response to 9/11, U.S. government has spent $160 billion in additional security. Also, many U.S. cities and businesses have spent millions of dollars to install or upgrade their security systems, and modifying their operations to comply with the new legislation, such as the Patriot Act. If the U.S. goes to war with Iran, the cost of security will surely increase dramatically.

Risk to U.S. Interests Overseas: With most U.S. companies now having a footprint in the global economy, our interests abroad are substantial. Many companies have offices and factories in third world countries that have lower level of security. It is highly probable that a war with Iran will have a direct negative repercussion to these facilities.

Risk to U.S. Travel Abroad: Iranians have been known to sponsor terrorism. A war with Iran will escalate Iran sponsored terrorist acts, especially on U.S. citizens abroad. The probability of hijacking, kidnapping, and killing of U.S. citizens while abroad on business or pleasure will dramatically increase.

Risk To Our Personal Freedom: Our constitutional rights have been trampled upon with our tacit assent shortly after 9/11. We now have wiretapping of phone calls, FBI surveillance of emails and other forms of communications, added level of security screening at airports, and even bag checks and fingerprint screening at Disney World. If we enter a war with Iran, the risk that our freedom may be further limited in the name of security.

No Benefit From A War With Iran

While the risks are great, there are no substantial benefits from a war with Iran, even if it was a quick one.

In looking back at the ‘benefits’ stated by M. Bush for going to war with Iraq: Promoting Democracy in Iraq by removing the Dictator Hussein, Combating Terrorism, Going After Al Qaeda, and eliminating WMD. Of these ‘benefits,’ the war in Iraq managed to achieve none of these. In fact, I think that we are in a worst situation than before the war.

What Is Bush Thinking?

I think Robert Draper in his book DEAD CERTAIN, The Presidency of George W. Bush nails the reason why Mr. Bush will not change his tactics and try diplomacy with Iran. In sum, Mr. Bush is stubborn, obstinate, and willfully optimistic that he is right. And anyone who disagrees with him is removed.

This view is echoed by former Treasury Secretary Paul O’Neill. According to the CBS report, Mr. O’Neill stated that:

“From the very beginning, there was a conviction, that Saddam Hussein was a bad person and that he needed to go,” says O’Neill, who adds that Bush “did not make decisions in a methodical way: there was no free-flow of ideas or open debate.”


”he [Paul O’Neill] thinks the Bush Administration has been too secretive about how decisions have been made.” and that “At cabinet meetings, he [Paul O’Neill] says the president was "like a blind man in a roomful of deaf people. There is no discernible connection," forcing top officials to act "on little more than hunches about what the president might think."

Thanks Goodness For Term Limits

Luckily we have Presidential term limits. Hopefully, we can prevent Bush from starting a war just long enough to elect a new president who would look at international policies in a more rational light. I don’t know who the next President of United States will be. But, if this video is any indication, Mr. McCain may be another one who feels that use of force is better than talking.

Ed Kim

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Tuesday, March 11, 2008

Risk of Ignorance – Failure of the Abstinence Education

USA Today reported,yesterday, citing a CDC study, that one out of four teenage girls had STD (sexually transmitted disease):

“The study by CDC researcher Dr. Sara Forhan is an analysis of nationally representative data on 838 girls who participated in a 2003-04 government health survey. Teens were tested for four infections: human papillomavirus, or HPV, which can cause cervical cancer and affected 18% of girls studied; chlamydia, which affected 4%; trichomoniasis, 2.5%; and herpes simplex virus, 2%…the results are similar to previous studies examining rates of those diseases individually.”

An April 2007 final report titled Impacts of Four Title V, Section 510 Abstinence Education Programs Final Report, April 2007 by Mathematica Policy Research, Inc. concluded that there were no difference in sexual activity or knowledge of STD between teenagers who attended the abstinence education program and teenagers who did not. According to the report, the Federal Title V, Section 510 program had funded $50 million annually, beginning from 1997, to various abstinence programs around the country.

Risk / Reward Results

Risk: Those who engage in pre-marital sex will increase the potential for contracting STD and/or getting their female partners pregnant.

Cost to Mitigate the Risk Through Title V, Section 510 program: $500 million over 10 years from 1997 to 2007.

Reward: No difference in sexual behavior or knowledge of the risks of pre-marital sex, including STD, between the group of teens who attended abstinence program and the group of teens who did not.

So in essence, we the taxpayers are allowing the government to give $50 million annually to various educational programs that has proven to not work.


The American Social Health Association, a non-profit organization formed in1914 to prevent sexually transmitted diseases. In their 2006 annual report, their total governmental support, Federal and State, was $164,342. Altogether, their 2006 revenue was $3.6 million.

It is clearly obvious that Abstinence program isn’t working. While I am not in favor or supporting pre-marital sex, especially among teens, I am in favor of not wasting money. If more than $500 million so far spent over 10 years to educate teens to not have pre-marital sex has not materially changed teen’s habits, then why continue funding a failed program?

Simple True

Teens will be teens. Think back at your own teenage years. Rebelling and trying something new and different were part of our teen years. Teens now are no different than teens hundreds of years ago. I leave you with the following quotes from history:

Little children, headache; big children, heartache (Italian Proverb)

I would there were no age between ten and three-and-twenty, or that youth would sleep out the rest; for there is nothing in the between but getting wenches with child, wronging the anciently, stealing, fighting. (William Shakespeare)

Ed Kim

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Random Musing On Access Security – Disney versus TSA

Notice: Random Musing is meant to amuse, pique curiosity, and add a bit of controversy by looking at issue from a completely different perspective. If you emote after reading the Random Musing, then it is working.

Why does Disney World in Orlando have biometric finger scanners and park pass readers at their entry gates? According to the local news report, Disney’s purpose of the biometric finger scanner was to keep track of legitimate use of tickets and not to gather personal data.

How Disney Security System Works
The system that Disney – and also Universal Orlando and SeaWorld Orlando – have in place is quite sophisticated. Each park pass has a magnetic strip like a credit card. When you buy a park pass, the purchase data, including the purchase price, point of purchase, date of purchase, and method of payment gets encoded onto the park pass magnetic strip. If you purchased the pass with a credit card, then your name is also embedded in the park pass.

Every time a person puts their park pass into the pass reader and have one of their fingers scanned, this information is relayed to a central computer system that verifies the validity of the pass and confirms the fingerprint to the biometric data associated with the pass. This ensures that the park pass cannot be given to another person. Green means fingerprint data has been associated with the pass and you can go in; Red light means, try again or access denied.

From a risk perspective, I could understand the need for Disney and co. to mitigate the potential risk of revenue loss. After all, without proper security, a person may try to use someone else’s park pass to enter Disney World, resulting in a potential loss of approximately $100 in park admission revenue per incident.

Why Can’t We Have Something Similar At Airports?Then a thought came to me: If Disney and other amusement park operators could install, maintain, and operate a sophisticated identity checking system at their entry points, then why can’t the TSA employ something similar?

After all, the TSA is in charge of security at airports. The risk of loss and severity of loss are much greater at airports than at an amusement park. One could reasonably expect that if Disney could install such sophisticated biometric finger readers and park pass verification system at all their entry gates to mitigate a potential $100 loss, then TSA should be able to install something comparable at airports, at least at the major ones.

Sadly, we don’t. Instead, we have, even at major airports, a system where TSA security agents looks at your government issued ID and boarding pass prior to your having to go through a metal detector and putting your bag through an x-ray machine. And, just as an added layer of security, there are abundant number of TSA agents supposedly looking at you, using their SPOT technique.

How secure is that? Not too secure. We know what happens when a person enters the airport terminal without proper security screening. In November 2001, at the Atlanta airport, Mike Lasseter caused a nationwide flight delay simply by running past security guards and into the terminal.

Even when an idiot inappropriately jokes about a bomb in his bag, the airport shuts down for couple of hours. How about when a TSA agent makes an honest mistake? Apparently, an honest TSA mistake will also shut the airport down for three hours.

I can fully understand and appreciate the need for security at our airports. However, I cannot understand how the entire airport can be shut down and evacuated for several hours every time there is a false alarm from an idiot joking about an explosive in his bag or when a TSA agent makes an honest mistake.

The cost for a multi-hour airport evacuation and flight delays resulting from the evacuation would run into hundreds of thousands of dollars. In the cases of an airport the size of ATL or LAX, cost would run into tens of millions of dollars.

The Big Question
So does TSA have a way to reduce the ‘false’ positives? Nothing so far. Which brings us to the big question:

If Disney World, which has approximately 50 million visitors a year – putting it on par with a busy airport, such as JFK, which had approximately 49 million passengers in 2007 – is able to handle the flow of visitors through the entry gates without minimal delays, even with octogenarian monitoring the security process, then why is TSA still using a legacy security procedure and system - that critics have labeled as inadequate?

Sad Conclusion
I don’t know about you but from a risk manger’s perspective, there is something really wrong here if we cannot have an effective airport pre-boarding security screening while Disney has one for their entry gates.

Perhaps, we should have Disney take over the TSA function. After all, a lot of people think the TSA is a “Mickey Mouse” organization.
Click here to see a news video on how Disney’s biometric systems work. TSA, please have a pen and paper ready before you watch the video, you may learn something.

Wishing You a Million Happy Dreams,
Ed Kim

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Risks From Fed’s $200 billion Term Securities Lending Facility

The Federal Reserve, trying valiantly to stem the market forces for sometime, has now taken an extraordinary step of expanding their role in the current credit crisis. With the announcement that the Fed will lend $200 billion in cash and U.S. Treasuries and extend the lending term from overnight to 28 days, the risk meter, which was already at High Alert, just went to Critical.

Here are the risks, as I see them, from the Fed’s latest action

Increased Risk of Credit Malaise Continuing: By allowing brokers to swap their illiquid securities such as non-agency AAA/Aaa rated MBS for highly liquid UST (U.S. Treasuries) and cash, the Fed is in essence injecting $200 billion directly into the system. While this will have an immediate uplifting effect on the market, it will soon wear off as investors see additional signs of economic softening. Much like a junkie, it will require even more potent capital injection to achieve the same ‘high’.

Increased Risk to the U.S. Treasuries: The injection of $200 billion in cash and UST into the market will result in the reduction of the perceived value of the UST by the international investors. The perception of lower value of the UST is the direct result of the Fed’s announcement that it will accept AAA/Aaa rated non-agency MBS as collateral for the 28-day loan. Since investors know that the credits rating on the non-agency MBS bonds are suspect, the market for them is illiquid. However, since the Fed is willing to accept the face value of them as collateral for UST or cash, it creates a perception in the international investment community that the U.S. Government is resorting to irrational measures to save its economy. Due to the negative perception that the U.S. may be over-extending itself, foreign investors, who otherwise may have bought UST, will instead stop buying or will demand a lower price for the UST, driving the yield higher.

Increased Risk to the U.S. dollar: Fed’s latest action is a clear signal to the international investment community that the U.S. Government will go to all lengths in trying to revive its economy, including increasing the supply of dollars through other Central Banks, such as the Bank of Canada, Bank of England, European Central Bank, and the Swiss National Bank.[i] As the supply of dollars increase worldwide, the perceived value of it will fall further against other major currencies.

Increased Risk of Hyperinflation: As the foreign exchange of the Dollar decreases against other currencies, due to increased worldwide dollar supply, cost of imports will increase while the purchasing power of the dollar will decrease. With a stalled economy, weak job market, and stagnant wages, further devaluation of the dollar will drive up the prices of goods even more. The days of $4 gallon of gas and $5 gallon of milk seems more probable now than before.

The Fed hopes that the Brokers will take the cash and UST it borrowed and lend it in the market, thereby reviving the market’s vitality. However, the Brokers are suffering from lack of capital and, given the worsening economy, are hesitant to lend. Instead, they will use the cash and UST to shore up their balance sheet, even if it is for 28 days. If the Brokers do lend the money, it will probably be to an international counterparty, whose economy is in better shape than ours. Therefore, in the end, the Fed’s action today will only increase the risks to the U.S. market while stalling the inevitable market crash for a little while longer.

Ed Kim


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Monday, March 10, 2008

Will GM Or Ford Survive The Current Economic Crisis?

With the price of gasoline in the U.S. continuing to go up while consumer spending is going down, there are concerns about the continued viability of the U.S. auto manufactures to survive this economic crisis. Certainly, the U.S. auto makers faced and survived previous economic challenges – such as the 1973-74 gas shortage[i], 1979 gas shortage[ii], 1980’s Japanese car invasion, 1998 workers strike, 1990-91 recession, and the 1990’s Korean car invasion, to name a few – however, the challenges facing the U.S. automakers this time appears to be more difficult than in the past.

What Is Different This Time?

In a word: PROFIT

GM and Ford had been profitable year after year up until 2000. According to Institute for Foreign Economics, the combined annual profit of the three major U.S. automakers, including Chrysler, was $13 billion a year from 1993 to 2000[iii].

Since 2001, which was the turning point for GM and Ford, they have been losing market shares to foreign makers, especially the Japanese, who enjoyed the foreign exchange advantage as their currency went from 116 yen to a dollar in January 2001 to 135 yen to a dollar at the end of 2001. In fact, Morgan Stanley estimated that Toyota earned $125 per vehicle for every one yen drop versus the dollar[iv]. In addition to lower prices, Japanese automakers were producing better built cars with better ergonomics.

Now, after years of trying to compete with foreign automakers on price, incentives, and low financing rates, GM and Ford are in a catch-up mode, particularly with the very items that lost them the market share in the first place: building ergonomically designed, high-quality cars at an attractive price.

According to GM’s website, their FY 2007 financial results were bleak:

“General Motors Corp. (NYSE: GM) today announced a 2007 calendar-year adjusted net loss, excluding special items, of $23 million, or $.04 per diluted share. This compares to adjusted net income of $2.2 billion, or $3.84 per diluted share in 2006, as significantly improved automotive performance was offset by large losses at GMAC. Including special items, the company reported a loss of $38.7 billion, or $68.45 per diluted share, compared to a reported loss of $2 billion, or $3.50 per diluted share in 2006. The loss is almost entirely attributable to the non-cash $38.3 billion special charge in the third quarter related to the valuation allowance against deferred tax assets.”

In their Future Outlook, GM states, quite optimistically:

“Operating cash flow is expected to be relatively flat in 2008 versus 2007, despite planned increases in capital spending to about $8 billion, up from $7.5 billion in 2007. GM remains confident in the 2010-2011 opportunities to further improve earnings and cash flow.”

So, GM is forecasting no improvement in earnings until 2010.

How about Ford? Well, they also sounded optimistic about their 2007 financial results:

“Full-year net loss of $2.7 billion, an improvement of $9.9 billion from 2006. Fourth-quarter net loss of $2.8 billion, an improvement of more than $2.8 billion from 2006.

For the full year, Ford's worldwide Automotive sector reported a pre-tax loss of $1.1 billion, compared with a pre-tax loss of $5.1 billion a year ago. The improvements primarily reflected higher net pricing, lower costs, and favorable mix, partially offset by unfavorable changes in currency exchange rates, and higher net interest expense.”

As for their future projection, they were not as adventurous as GM, as Ford only talked about 2008. Even then, the outlook is not rosy:

“Although our Automotive operations are improving on a year-over-year basis, the U.S. economy is slowing and the outlook for the auto industry remains challenging," said Ford President and CEO Alan Mulally.

Risks GM And Ford Must Overcome To Survive

GM and Ford - Risk of irrelevancy: As Japanese and European cars continue to dominate JD Powers Quality survey, year after year, GM and Ford will become more irrelevant, especially to the younger generation of car buyers. Toyota has already been working to attract the younger generation through their Scion specialty brand, which does not even advertise on Toyota’s own website. While Ford and GM, with their recent revival of the muscle cars, may get a little boost from the nostalgia crowd of baby boomers, they have not made any serious traction with the younger buyers, who are opting for Japanese cars.

This issue was clearly noted by a February 2006 study Vehicle Choice Behavior and the Declining Market Share of U.S. Automakers[v] by Kenneth E. Train and Clifford Winston. This study concluded that the way forward for GM and Ford is to offer what a good quality mid-size car that is generally pleasing to the public, reliable, and priced to compete [bold and italic added for emphasis]:

We find that the U.S. industry’s loss in share during the past decade can be explained almost entirely by relative changes in the most basic attributes of new vehicles, namely price, size, power, operating cost, transmission type, reliability, and body type. The result is surprising in its simplicity, implying that it is not necessary to resort to the plethora of explanations just described. Arguments based on subtle attributes such as the design of interior features, unobserved responses by consumers to vehicle offerings, or even measurable attributes beyond those listed above do not play a measurable role in the industry’s competitive problems. Similarly, changes in loyalty patterns, whether an automaker’s product line is broad or narrow or includes a hot car, and changes in dealership networks do not contribute much to the industry’s decline. Our finding suggests that U.S. automobile executives should focus more attention on understanding why their companies seem unable to improve the basic attributes of their vehicles as rapidly as their foreign competitors are able to improve their vehicles’ basic attributes, and try to remedy the situation.

GM - Risk of Current Labor Unrest Continuing Much Longer: GM is again being adversely affected by another labor strike, this time with the American Axle and Manufacturing Holdings Inc., a major parts supplier. Given the current oversupply of unsold inventory, the strike will have a muted effect on car sales, if it is a short one. However, given the width of the gap in hourly pay, this may last awhile, eventually hurting GM in the revenue numbers. According to a MarketWatch report:

“Talks resumed Thursday for the first time since the strike began. The talks focus on issues such as American Axle's aim to pare its total labor cost, which includes benefits, to $27 an hour from where it stands now at $73 an hour.”

GM - Risk of Funding Retiree Benefits: According to GM’s website, the funding shortfall of “approximately $4 billion will be funded with a short term note maturing January 2010 with interest at 9 percent.” According to CNN Money, there is an additional $33 billion to $36.5 billion that GM would have to put into the healthcare trust. However, GM’s 2007 financial statement notes that the funding of this will be through a series of derivatives to effectively reduce the $40 per share convertible note to $36 per share, if it works. Moreover, this structured finance would entitle GM to recover the additional economic value provided if the GM stock price appreciates to between $63.48 and $70.53 per share[vi]. This sounds like GM setting itself up for another fight with the Union on benefit shortfall come 2010.

Ford - Risk of Bankruptcy: In 2006 Ford underwent a major restructuring dubbed the “The Way Forward.” Through drastic cost cutting, plant closing, worker buy-outs, and sale of subsidiaries, Ford had projected to return to profitability by 2009. Ford effectively boxed itself into a corner by taking out $23 billion in financing by mortgaging its assets. While Ford had $34.7 billion in cash at the end of 2007, their projection of spending $6 billion on capital improvements in 2008 while expecting losses again on its automotive unit, Ford will be burning through their cash very quickly[vii]. With declining sales projected for 2008, the potential for Ford to enter bankruptcy will increase as 2008 progresses. This is clearly evidenced by Fitch’s February 2008 rating action, which rates Ford’s issuer default as 'B' with a negative rating outlook.

Given that the U.S. economy is in a recession and may be heading toward a depression, the likelihood of GM and Ford being able to return to profitability in 2008 is seriously questionable.

May your trading be profitable.

Ed Kim

DISCLOSURE: The author holds no positions in GM or F at this time
[iii] , page 140
[iv] , page 142

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Business Risks From Current Credit Derivatives Market Turmoil

Financial Times reported today on the Credit Derivatives Market Turmoil:

“Turmoil in the credit derivatives markets is having an increasingly brutal impact on the wider financial system as a vicious cycle of forced selling drives risk premiums on company debt to new highs.

The trend accelerated on both sides of the Atlantic last week as investors rushed to unwind highly leveraged positions in complex structured products. The cost of protecting US investment grade debt against default soared to a high of 188 basis points, from 80bp in January.”

With the current turmoil in the credit derivatives market, the business risks have substantially increased. Here are a few of the risk factors rising from the credit derivatives turmoil that I think any prudent financial manager should take into consideration:

Counterparty Default Risk: For those investors who are “In the Money,” the focus is on whether the counterparty, the party who is on the other side of the trade and owes the money, can pay on the trade. As the uncertainty of the counterparty’s ability to pay increases, investors will choose to buy credit default swaps (CDS) to hedge against the possibility of the counterparty not being able to pay.

Leverage Risk: For those investors, such as hedge funds, who had borrowed money to buy credit derivatives, managing their leverage risk becomes important. Typically, being leveraged 10 to 1 or more, any drop in the value of their credit derivatives will trigger a margin call from the lender. If the investors do not have sufficient cash or cash-equivalents, typically UST, to provide additional collateral to the lender, the lender may force the investors to liquidate some or all of their credit derivatives holdings. This forced liquidation drives down the value of the credit derivatives.

Market Risk: As more investors begin selling credit derivatives to meet margin calls, the risk of these investors not being able to meet the margin call or going out of business increases. This will force lenders to buy new or additional CDS as insurance. As more lenders buy CDS, the price of CDS increases. This is clearly evident in current markets as reported by the Financial Times.[i]

Liquidity Risk: As more lenders worry about whether they will be made whole on credit derivatives trades, their expenditure on CDS increases, resulting in lower earnings. As the risk of counterparty default increases, there is less desire on lenders to lend. As lenders slow or even stop their lending, a liquidity crunch will occur, forcing borrowers to seek alternative and more costly sources of funds.

Modeling Risk: As the volatility in credit derivatives pricing increases, the risk of the models used to price the credit derivatives being inaccurate increases. The underlying variables used to value the credit derivatives may not be updated on a timely basis, causing incorrect position marking and financial reporting requirements. This may result in material financial losses. As models' complexities have increased over the years, teams of ‘quants’ are now required to maintain the integrity of the models used to price and trade credit derivatives. For investors who rely on monthly review of their models' integrity, their risk of mis-pricing and/or mis-marking their credit derivatives positions have increased.

Financial Risk: Due to the complexity, lack of transparency, and difficulty in properly pricing and marking credit derivatives, the risk that an investor may incorrectly price their credit derivatives positions has increased. This may result in material financial losses from the incorrect mark-to-model pricing.

Reputational Risk: Some counterparties who have reported or to report financial losses may see rating agencies reviewing their credit ratings for possible downgrades. Although the downgrades may not occur, the perception of credit weakness will result in higher cost of CDS to the lender, should they decide to lend. This perception will reduce their ability to borrow at a favorable rate or miss investment opportunities.

According to the Federal Reserve Bank of Atlanta, the credit derivatives market as of second half of 2006 had a notional of $35 billion[ii]. According to ISDA, International Swaps and Derivatives Association, the notional value of the CDS (credit default swaps) in 2006 was $34.6 trillion, an increase of 102% from 2005[iii]. According to the Fed Reserve, the total outstanding corporate debt at the end of 2006 was $6.3 trillion[iv]. In other words, the credit derivates market is equivalent to the CDS market, both of which are 5.5 times greater than the actual outstanding corporate debt.

What this implies is that majority of the credit derivates are speculative and nearly fully hedged. However, this picture will become very sullied as the counterparty default risk continues to increase. If that happens, which I think will be the next phase of the credit unwinding, the cost of CDS will continue to go higher.

Ed Kim
Practical Risk Manager

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Sunday, March 9, 2008

Rising Diesel Fuel Price’s Negative Effect On The U.S. Economy

In the continuing look at the increasing oil price in the U.S., this article will focus on the impact that increasing diesel fuel price will have on the U.S. economy.

Trucks Are Vital To The U.S. Economy
According to the Research and Innovative Technology Administration (RITA), trucks transports approximately 70 percent of the total value of all goods in the U.S.[i]:

“…trucking as a single mode was the most frequently used mode, accounting for an estimated 70 percent of the total value, 60 percent of the weight, and 34 percent of the ton-miles. In 2002, the trucking industry, both for-hire and private own-use, transported over $9 trillion worth of shipments…”

Additionally, trucks carried over $491 billion, or 62 percent, of the total value of U.S.-NAFTA merchandise trade in 2005[ii]. Given these facts, the importance of trucks’ role in the U.S. economy can be firmly established.

No True Alternatives To Trucks
The alternatives to trucks as a mode of intra-U.S. transportation of goods are limited to trains, planes, and boats. Since the river and canal systems in the U.S. are not extensive or provide direct point-to-point connections, boats would be poor alternative to replace trucks.

Airplanes have the ability to quickly deliver goods and are able to modify delivery points while in transit. However, the cost per ton of goods is the most expensive of the four alternatives. Moreover, the airplanes are not a true point-to-point mode for transporting goods as the initial and final legs of goods transportation must be made by other modes, mostly by trucks. While airplanes serve a vital role in transporting goods that are highly perishable or require fast delivery, the airplanes will not replace trucks for transportation of goods within the U.S. due to its high cost.

Trains come the closest to meeting trucks in transporting bulk goods within the U.S. While trains transport more ton-miles of freight than trucks – 1,733,777 million ton-miles for trains versus 1,293,326 million ton-miles for trucks, out of a total of 4,537,921 million ton-miles in 2005[iii] – they do not have extensive rail network to effectively compete with trucks[iv]. Moreover, as in the case of airplanes, the initial and final legs of goods transportation must be made by trucks.

What Does This Mean?
With no true replacement for trucks in providing a true point-to-point transportation of goods, any increase in the cost of diesel fuel will have a direct effect on the cost of goods and productivity of U.S. companies as trucks are an integral part of transportation of raw materials and finished goods within the U.S. and between NATFA countries.

A Penny Here And Penny There…Soon It Becomes Material
In 2005, trucks, as defined as single-unit 2-axle 6-tire or more and truck combination, traveled over 222.8 billion miles, according to RITA[v]. At an average 6.7 miles per gallon, the trucks are not very fuel-efficient[vi].

Therefore, cost of fuel is critical for the trucking industry and for the U.S. businesses that rely on trucks to transport their raw materials and finished goods.

Click to enlarge
Click to enlarge
Data Source: and; 2006 and 2007 miles traveled and fuel consumed, extrapolated using the % increase from 2004 to 2005.

Overall, truck vehicle-miles have increased from 209 billion in 2001 to 222.8 billion in 2005 (and extrapolated to 226.9 billion in 2007, using 0.92% annual increase from 2005 figures), an 8.6% increase. During the same period, the #2 diesel price per gallon rose from an average of $1.40 per gallon in 2001 to $2.88 per gallon in 2007, a 105% increase. The most recent price for a gallon of #2 diesel fuel was $3.66 nationwide, as of March 8, 2008[vii] (or an additional 27% increase from 2007 average price). The increased cost of diesel fuel was partially mitigated by increased MPG efficiency, which went from an average of 5.8 miles per gallon (MPG) in 2000 to 6.8 MPG in 2002.

Rising Fuel Cost Poses Risk To Financial Health Of U.S. Businesses
According to RITA, truck’s average freight revenue per ton-mile (moving one ton of good one mile) from 1990 to 2001, the years of the available data, was $0.255 – the highest freight revenue per ton-mile was in 2000 at $0.27[viii]. Figures for 2002 to 2007 were extrapolated using the average year-over-year growth rate of both Ton-Miles and Revenue Per Ton-Miles from 1990 to 2001 of 3.88% and 1.10%, respectively. Based on the estimated growth rate, it reasons that the revenue growth lags the rapid increase in fuel cost.
Click to enlarge
Data Source: and; 2002 to 2007 Ton-Mile and Revenue per Ton-Mile were extrapolated using the respective average % increase from 1990 to 2001.

With diesel fuel price increasing much more rapidly than revenue, it becomes very clear that the cost of transporting goods has to go up. However, the increased fuel cost has not fully manifested itself in the cost of goods, so far.
Click to enlarge

When will the rising fuel cost finally manifest itself in the PPI numbers? It is only a matter of time but that time is rapidly approaching. Based on the PPI for freight trucking, the preliminary numbers for 4Q 2007 indicates that the increased fuel cost is being passed on. If the fuel cost stays or increases over its current levels, expect the final 4Q 2007 PPI numbers to be revised upwards.

Potential Risk Events From Rising Diesel Fuel Price

§ Rate of independent truckers going out of business will increase as the rise in their fuel cost overwhelms the growth in revenue per ton-mile.
§ As number of independent truckers decrease, the total number of available trucks to transport goods will decrease, keeping a floor on the cost of transportation of goods.
§ Businesses, seeing their profit margin shrink as transportation cost increases, will begin to pass on the additional cost by increasing their prices.
§ As more independent truckers go out of business, shortages of trucks to transport goods will result in certain goods being unavailable in certain sections of the country, artificially driving up the prices of those goods in those affected regions much higher than expected.
§ As a reaction to the overall rising prices, more consumers will begin switching to lower cost alternative or even cut back on their rate of consumption to save money and/or make their dollar last.
§ Business defaults will increase, particularly those businesses that are unable to monetize their receivable (AR) quickly or have to pay much higher factor to monetize AR.

The above scenarios may be all doom and gloom but it is a path that the U.S. economy is currently on, unless dramatic government intervention occurs. As a risk manager, it is my position to assess the risks and potential losses arising from the expected risks without sugarcoating the truth.

Now, being informed, do your own due diligence and draw your own conclusion. Be free to agree or disagree with my assertions. However, whatever you decide, use that decision wisely in your investment choices.

May your trading be profitable.

Ed Kim

DISCLOSURE: The author holds long positions in Oil Refining Companies at this time
[v] and[vi] Calculated using the Vehicle-miles traveled (millions) and Fuel consumed (million gallons) of RITA tables 4-13 and 4-14

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