New Risks for Municipal Bond Investors

New Risks for Municipal Bond Investors

Hey! Mom-and-pop retail investors still own about 75% of the municipal bond market (directly or indirectly). They want a stable asset class with relatively few defaults, high credit ratings and interest income that’s tax free at the federal, state and local levels, if possible. In short, they want their father’s Oldsmobile.

Yet, today we’re seeing more stressed municipal credits than ever. Detroit, Michigan, filed for Chapter 9 bankruptcy protection in 2013 and is now the largest municipal bankruptcy filing in U.S. history at $18 billion. In this environment, there are new risks for municipal bond investors to evaluate. So investors should think again and remember the old advertising slogan: This is notyour father’s Oldsmobile—or his municipal bond either!

Public Finance: Key Issues and Red Flags 

To address this timely topic, the CFA Society of Chicago brought a panel of experts together for a program entitled: Uncovering Value and Risks in Stressed Municipal Credits. The panel was moderated by Arlene Bohner, Senior Director U.S. Public Finance, at Fitch Ratings and provided forward-looking insights on how to navigate these uncharted waters.

Bohner opened with a big picture overview of key state credit issues. She noted that U.S. states have broad economies and tax bases with substantial control over spending and raising revenue and this, in turn, generally supports their higher credit ratings. However, most governments made heavy cuts during the ’08-’09 recession and are still challenged by higher labor costs, pension funding deficits and huge infrastructure needs.

Longer-term, Bohner feels states remain significantly exposed to the possibility of federal funding cuts (e.g. Medicaid), although Bohner says, “Fitch believes states would have time to adjust to any significant federal actions.” Even still, Fitch has Connecticut, Illinois, Mississippi, and New Jersey currently on a negative outlook yet feels most state ratings will remain stable. In addition, she notes that steep cuts to vulnerable discretionary programs and/or federal tax code changes could have significant effects on state budgets and economies over time.

At the municipal level, Bohner looks for a number of red flags including:

  • Declining revenue base
  • Declining population and/or school enrollment
  • Increasing unemployment rate, coupled with a declining labor force
  • Relatively high tax burden
  • High and rising fixed cost burden
  • Declining assessed property valuations
  • Large debt issuances for controversial / non-essential projects
  • High levels of variable rate debt or swap obligations (> 15% of total debt)
  • Unusually contentious relationships among officials and/or with the State (including poor relationships between management, labor and taxpayers)
  • Inability to resolve labor disputes
  • Long-term labor contracts with inflexible terms
  • Low pension funding ratios with payments below actuarial required contributions (ARC)
  • Agressive budgeting and/or economic assumptions
  • Weak disclosure practices

Bohner now expects to see increased debt issuance at the municipal level to address deferred maintenance and capital needs. She notes that “pay-go” capital spending, which uses savings or current cash flow to finance projects, was reduced or eliminated by most governments well into the recovery. She also cautions investors about the increasing use of direct bank loans (private placements) for municipal financing due to their lack of transparency.

Forward-looking Municipal Metrics

Richard Ciccarone, President and CEO, Merritt Research Services LLC, reported that most cities experienced net general fund deficits from 2008 through 2010 and this was a reflection of the economic downturn. During this period, as many as 62% of big cities (over 500,000 population) and 58% of all cities reported deficits. But Ciccarone points out that Meredith Whitney’s prediction of billions being lost in the muni bond market didn’t come true and that general fund deficits returned to the 23% to 41% range between 2011 through 2014 (see graph below).

Percent of Cities with a Net General Fund Deficit                                    

 All Cities vs. Biggest Cities (Over 500,000 Population) FY 2006-2014

Source: Merritt Research Services, LLC

But that’s ex post information and investors need effective ex ante tools to guide future investment decisions. Ciccarone says, “in almost all distressed situations the unrestricted net asset ratio is negative.” Ciccarone started using this ratio around 2000 and says it has key predictive capability. As shown below, the ratio compares unrestricted net assets, which are resources considered usable for any purpose (numerator), to governmental activities expenditures, which are outflows of resources recorded on the government-wide financial statements per GASB Statement No. 34 (denominator).

Source: Merritt Research Services, LLC

Like a coverage ratio, this metric illustrates the availability of funds relative to expenditures—so the higher the ratio the better. As shown below, the largest cities (a with population over 500,000) have fallen into negative territory since 2009. Meanwhile, for all of the 2,000 cities in Ciccarone’s study, unrestricted net assets were between 20% to 23% of governmental activities expenditures from 2011 to 2014.

Importantly, we need to look at the government-wide balance sheet rather than the fund accounting statements that ignore long-term liabilities. Remember that governmental fund accounting focuses on the short run. But the government-wide balance sheet will reveal pension obligations, OPEB, debt and contra assets with deficit financing and no assets or revenue supporting them.

In regards to significantly underfunded pension obligations, Ciccarone’s big concern is that they may restrict a municipality’s ability to provide essential services (police, fire, garbage, etc.). He emphasized that Chicago’s actuarially required pension contribution (ARC) was as high as 55% of its general fund expenditures in 2014. That’s more than three times the level of other big cities (with a population over 500,000) as shown below. However, like many big cities, Chicago actually paid in far less to its pension plans than its actuarially required contribution levels.

Pension Requirements for Chicago and Big Cities:                          

Annual (Actuarial) Pension Cost as a % of General Fund                                                             Single Employer Plans only (2007-2014)

 Source: Merritt Research Services, LLC

Watch the Early to Mid-Career Numbers

Ciccarone’s final piece of forward-looking advice is to watch the early (25-29 years) to mid-career (30-34 years, 35-39 years) population numbers. These numbers tend to fall in distressed areas and Ciccarone says we need to watch them closely for Chicago. The charts below illustrate the decline for fallen angelslike Detroit and Puerto Rico. Fortunately, Chicago appears to be holding its own on these metrics and/or increasing in some areas.

Detroit Early to Mid-Career Population Groups                                      

(25-29 Years, 30-34 Years and 35-39 Years)

Source: Merritt Research Services, LLC & Government Census Data

Puerto Rico Early to Mid-Career Population Groups                            

(25-29 Years, 30-34 Years and 35-39 Years)

Source: Merritt Research Services, Inc. & Government Census Data

Chicago Early to Mid-Career Population Groups                                      

(25-29 Years, 30-34 Years and 35-39 Years)

Source: Merritt Research Services, Inc. & Government Census Data

Bankruptcy – Is the stigma is gone?

 Shawn O’Leary, Senior Vice President, Senior Research Analyst at Nuveen Investments is concerned that the stigma associated with default is gone. O’Leary noted that historically there’s been a significant fear of losing access to credit markets during bankruptcy. Yet he points out that  Detroit, Michigan, Jefferson County, Alabama and Stockton, California all refinanced and gained market access after bankruptcy. These cities are among the top five municipal bankruptcies in US history (below).

The 5 Biggest Municipal Bankruptcies in US History 

  1. Detroit, Michigan (2013)                                          $18 billion
  2. Jefferson County, Alabama (2011)                           $4 billion
  3. Orange County, California (1994)                            $2 billion
  4. Stockton, California (2012)                                        $1 billion
  5. San Bernardino County, California (2012)       $500 million

 Source: Forbes/Capital Economics

Ciccarone agrees with O’Leary and feels that in this environment the potential for more bankruptcies is definitely there—especially if policymakers approve additional bankruptcy statues like the one Governor Rauner proposed in Illinois. Today, approximately 24 states have been granted bankruptcy rights by their State legislatures but U.S. Territories, like Peurto Rico, cannot.

Lessons from Detroit

Bill Grady, CFA, Senior Portfolio Manager, Allstate Investments says that the problems in Detroit were brewing for decades. Grady says, “if you didn’t see them coming—shame on you.” After all, Detroit lost 50% of its population over the last 11 years. And looking even further back, it had been consistently losing population since the 1950s. Today, Grady hears even more municipalities talking about using bankruptcy as a negotiating tool.

O’Leary quickly added that people assume “special revenue bonds” will always pay principal and interest. In the case of Detroit, O’Leary was stunned by a federal judge who wanted to transfer his investors’ collateral (on water and sewer lines) out for ten years in order to redirect payments to unsecured creditors ahead of him. Even some attorneys suggested that he really wasn’t a secured creditor because Detroit had billions in unfunded capital expenditures. Ultimately, he says it took the ratings agencies to help force a tender offer by insisting that paying less than what’s due is recognized as a default.

Puerto Rico – Neither Fish nor Fowl

According to Bloomberg’s Michelle Kaske and Martin Braun, at $72 billion, The Commonwealth of Puerto Rico has more debt than any U.S. state government except California and New York and had been borrowing to pay its debts when they came due, until it defaulted on its payments in August 2015 (see Puerto Rico’s Slide, Bloomberg Quick Take 10/22/15). Notably, Puerto Rico’s bonds are exempt from local, state and federal taxes everywhere in the US—which made it easy for the US territory to double its debt in ten years.

O’Leary explains, “the problem with Puerto Rico is that it’s neither fish nor fowl.” O’Leary says it’s not a true sovereign nation (so they can’t go to the International Monetary Fund) and, unlike municipalities, it doesn’t have collective action clauses which would enable bondholders to implement a debt restructuring plan as long as the majority agrees. Rather, it’s like U.S. states that can’t file for bankruptcy. Hence, Puerto Rico can only ask for a settlement and that encourages creditors to holdout during negotiations. Ultimately, O’Leary feels the federal government needs to step in and make a deal happen.

To that end, on October 21st the Obama Administration announced its support for legislation that would grant Puerto Rico Chapter 9 bankruptcy protection, and a legal framework for U.S. Territories to conduct debt restructuring. Only time will tell if Congress will approve such a measure.

Bill Grady wraps up by saying, “hedge funds are controlling billions of dollars in bonds in Puerto Rico so it’s nearly impossible to take a position there without exceptional research capabilities.” In the end, Ciccarone thinks bondholders will probably recover between 40% to 70% of their investment—at typical sovereign default rates—while noting that the Puerto Rico’s 8% bonds have recently been trading in that range.

A Crisis in Illinois?

Illinois currently has an underfunded pension system of over $100 billion and the lowest credit rating of any state. Notably, Fitch lowered its rating on Illinois’ general obligation bonds to BBB- (just three steps above junk status) on October 19th and Moody’s downgraded the GO bonds to Baa1 on Oct 28th. And we shouldn’t forget that the state of Illinois has been operating without a budget since July 1, 2015. Bill Grady says, “Illinois and Chicago have been penalized but haven’t hit money yet.” So he wouldn’t handicap either as buying opportunities at this point saying, “you would need a cast iron stomach.”

Finally, Ciccarone thinks there will probably be a crisis at the Chicago Public Schools (CPS) first, then there’s the potential for a happy ending. Chicago has a $20 billion unfunded pension liability and has serious structural budget gaps. On the bright side, Ciccarone points out that Chicago’s school, city and county taxes are still only half that of New York on a per capita basis. And on October 28th, the Chicago City Council passed a $543 million property tax increase to be phased in over four years which will help maintain police, fire and other city services. But he still thinks there will be a lot more paper sold and people losing money before it gets better.

In closing, I’d simply add that these risks do not mean that we should avoid the municipal bond market. Rather, we should consider the relevant factors and metrics described above to carefully select the right municipal bond issues for our portfolios. When given a choice, choose well!

Distinguished Speaker Series: Kurt Summers

KS Photo (new)On October 1, 2015, Chicago City Treasurer Kurt Summers took time out of his busy schedule to present the latest on city finances to a packed room in Hotel Allegro.  Summers became Chicago’s Treasurer less than a year ago. In this role, he acts as Chicago’s investor, banker, and advocate.  During his presentation Summers discussed financial challenges and opportunities that Chicago faces and outlined plans to make his office more efficient and cost-effective for taxpayers.  He recently presented his first budget for the Office of the City Treasurer, with a goal of reducing taxpayer expense by 30% while doubling revenue.

One source of savings is at the Department of Aviation at O’Hare airport.  The Treasurer’s Office currently manages the Department’s $1.8 billion portfolio and only charges O’Hare $76,000 a year in investment fees.  This low rate effectively means Chicago taxpayers are subsidizing O’Hare’s investment management fees to the tune of approximately $1 million per year.  Summers plans to better align costs by charging O’Hare directly instead of having this cost subsidized by taxpayers.  By implementing similar measures the Treasurer’s Office can be fully funded without incurring taxpayer expense. Summers also aims to eliminate subsides and generate more revenue across the board.

Another recent initiative that Summers undertook was revising the official benchmark for Chicago’s investment portfolio.  Previously, the benchmark was the 90 day Treasury bill, which Summers felt set the bar too low.  His office decided to changed this to a bespoke benchmark to better reflect the risk-return profile of the city’s investments.  His office also instituted minimum credit quality standards for its entire portfolio.  Previously, credit quality standards were only applied to individual securities.  Finally, his office saw that Chicago had been holding an excess of working capital in the operations portfolio; enough capital to last for 2 months, even though GFAO standards only call for holding enough capital to last for 45 days.  Summers’ office responded by creating an operations reserve portfolio with slightly longer duration, which should generate an extra $30 million in revenue per year for the city.

Summers identified pension reform as the biggest financial problem facing the city of Chicago, and he bemoaned the fact that politics and egos can often get in the way of progress.  Even when proposals for pension reform get agreement from all relevant parties, there are still legal challenges, as some of these proposals have been struck down by the courts.  Large pension liabilities pose many problems for the city including reduced funding for schools and potentially higher taxes, which could drive residents away.

Finally, Summers talked about Chicago’s financial education program.  Initially, there were 130 different organizations in Chicago providing financial education with little coordination and no common set of curriculum.  Summers’ office created a financial education network, and the U.S. Secretary of Education Arne Duncan has referred to Chicago a “model city” for its approach.  Summers encouraged CFA members to volunteer their time and energy to assist in the program.

Ben Bernanke with Martin Wolf on the Global Financial Crisis

Ben Bernanke, former Federal Reserve Chairman, spoke with Martin Wolf, chief economics commentator and associate editor of the Financial Times, at the historic Chicago Theater about his new book The Courage to Act: A Memoir of the Crisis and its Aftermath. The book is Bernanke’s chance to take on some of his harshest critics and to explain, in great detail, the Federal Reserve’s role in saving the country’s financial system during the Great Recession. Bernanke was appointed chairman of the Federal Reserve in 2006, mere months before the financial system began to unravel. During his hour-long chat with Wolf, Bernanke talked about his childhood, Lehman’s failure, and his inability to refinance his home mortgage last year.

Bernanke grew up in South Carolina, where he and his grandmother often discussed the Great Depression, which he said sparked his interest in economics. He was particularly interested in the monetary policy failures of the Great Depression and how future crises could be handled without these mistakes. In fact, on Milton Friedman’s 90th birthday, Bernanke promised that he would het let monetary policy fail again.

Wolf pointedly asked about Bernanke’s decision to let Lehman fail. Bernanke contends that he did not let the bank fail; rather it was the only option. First, he points out that they did not miss the housing bubble. He noted that he spoke with then-President George Bush about what would happen if housing prices dropped significantly and they concluded there would be a recession, but it would be manageable. What they hadn’t anticipated was how quickly short-term financing to banks would dry up as the markets got spooked. This, he insisted, was a weakness in the regulations as the system had too much dry tinder.

Turning back to Lehman, Bernanke detailed the “Lehman weekend” which started with widespread calls from the financial media to let Lehman fail. He wanted to avoid this and hoped another bank would step in to purchase Lehman as JP Morgan had done with Bear Sterns. Two potential buyers stepped forward, Bank of America and Barclays, but after examining Lehman’s balance sheet, both declined. The next option was for the Fed to lend money to Lehman (as it did later with AIG), but Lehman had no good collateral against which it could borrow. In the end, Bernanke contends he had no choice and Lehman failed.Bernanke leaves fed

The mood lightened a bit during the audience Q & A, when Bernanke was asked about the lack of mortgage credit in the market today and whether he thought it had gone from too loose to too tight. Bernanke agreed and told of how he was prevented from refinancing his home because he no longer worked for the Federal Reserve and didn’t meet the bank’s minimum number of years of self-employment. Don’t worry, though, as soon as the media got wind of it, Bernanke was offered plenty of refinancing opportunities from other banks.

Distinguished Speaker Series: Dmitry Balyasny

Dmitry Balyasny, Managing Partner and Chief Investment Officer, provided an outline of his firm, Balyasny Asset Management (BAM), as well as thoughts on how a well-functioning hedge fund should be structured at a luncheon presentation hosted by CFA Society Chicago on September 10th, 2015.

Balyasny provided a summary of how he got his start in the business; beginning with trading short-term equity and futures, and later in a fund of funds analyst role. After a number of years of trading and fundamental analysis under his belt, Balyasny set up BAM in 2001. He happily advised BAM Atlas Global fund has never had a negative return since its inception (2002) and also noted that Atlas Global has a correlation with the S&P 500 since inception of .04.

Balyasny provided several tips on what it takes to build a good hedge fund complex, from returns to the overall culture, and include the following:

  1. Ensure that you have a low correlation index – Balyasny Dmitry headshot with tie 1consistently looks for uncorrelated managers; people that are doing different things (that add Sharpe).
  1. Promote a collaborative, partnership culture, and attract and retain talent through a culture of excellence.

According to Balyasny a good hedge fund is small to medium in size and has robust risk management separate from portfolio management, emphasizing sector specialization, and dynamic capital allocation.

How does BAM produce for their clients? Their source of alpha is primarily drawn from ideas – bottom up bets (big bets do not work). BAM generates alpha primarily from ideas, 87%, while sizing of the bet only accounts for 13% of alpha. Thus it is critical to have numerous good ideas.

Balyasny also noted that since the market is mostly efficient, alpha is typically acquired over a short period of time. Approximately 70% of BAM’s alpha is generated within four months of purchase; 44% in less than one month, and 26% in one to three months. Thus BAM turns over their portfolios frequently in an effort to generate alpha. The BAM model focuses on the short-term as they believe it is difficult to look out years into the future and have expectations hold.

Balyasny finished the discussion by answering several questions including an interesting question regarding fee compression in the hedge fund market. Balyasny thought it strange that nearly all hedge fund products are priced the same, the 2 and 20 model. “Either they are too expensive, they are not providing alpha, or they are too cheap.” Balyasny noted that BAM’s pricing structure pushes past the 2 and 20 to a higher level because of their delivery of alpha and in an effort to remain small.

State of the Unions: The EU and the US in the 21st Century

On September 9th, The Chicago Council on Global Affairs and CFA Society Chicago partnered together to welcome Mr. Van Overtveldt, Minister of Finance of Belgium since 2014.  He is an economist, journalist and writer based in Brussels. He has authored several books including, The End of the Euro, Bernanke’s Test and The Chicago School and is a contributor to the Wall Street Journal and other publications.  His presentation revolved around the topic of his new book, A Giant Reborn: Why the US Will Dominate the 21st Century.

Mr. Van Overtveldt began his presentation by referencing literature and writers, who from 1775 through 1965 had predicted the decline of America.  These people had failed to recognize the reasons why America came to dominate and why it will continue to dominate world affairs in the 21st century.  Mr. Van Overtveldt uses an economic based argument of American superiority based on three factors:

  • Human Capital and Knowledge (non-excludable and non-exhaustible)
  • Entrepreneurial Drive (favored in the US economy)
  • Globalization

The above factors have created the environment of what Mr. Van Overtveldt describes as “turbo-change” that thrives in America.  Other countries cannot cope with change the way Americans have demonstrated they can.  Change is part of America’s DNA.

Mr. Van Overtveldt then focused on why Europe and China will not challenge America in the foreseeable future, describing China as having the biggest economic bubble the world has ever seen.  The “Confucian Deal” of the Party guaranteeing jobs and higher wages in exchange for little or no freedom will not work.  In China, debt as a percentage of GDP has doubled since 2008 and overcapacity in real estate is demonstrated by vacant houses and apartments.  China is also surrounded by potential enemies such as Vietnam and Japan.

The European Union has really not achieved a union, since European countries have demonstrated that they will not yield their sovereignty.  Mr. Van Overtveldt argues that the French and German coalition that ran the European Union will no longer work as France’s economy has not been able to keep up with the German economy.

In the Q&A that followed the presentation, Mr. Van Overtveldt stated that the UK has a large influence on the European Union and that its vote to remain in the EU will be closely watched.  The UK’s influence is especially large in Germany.  He also briefly commented on the immigration crisis in Europe, stating that there is no mechanism to arrive at a consensus on this issue.

Mr. Van Overtveldt also demonstrated the effectiveness of the US constitution versus the ineffectiveness of the European Union by comparing the Greek and California bankruptcies. California was able to get money from Washington if it met certain conditions.  The Greeks were given certain conditions; however there was no legal right to enforce these conditions.  The EU had no legal right to dictate reforms as they had to be approved by the Greeks themselves.

Thrown for a Loop Scavenger Hunt

CFA Society Chicago has an established history of working to promote thoughtful analysis and prudent decision making among its members. But how adept would its members be at navigating and scrutinizing the very city they live and work in every day? On August 27th about thirty CFA Society Chicago members sought to prove their analytical skill outside the office at the Thrown for a Loop Scavenger Hunt. The event was organized by the CFA Social Advisory Group and conducted by Watson Adventures, a vendor who specializes in conducting scavenger hunts and has a footprint in several major cities.

Watson Adventures’ hunts are not scavenger hunts in the traditional sense in which participants locate and collect items based on clues, but are instead information-based scavenger hunts. Participants receive lists of hints prompting them to visit certain locations, examine details about those places, and answer cryptically-worded questions. As the name of the event suggests, the location for the CFA Chicago hunt was the entire Chicago Loop and the buildings and landmarks within the area. After assembling at Daley Plaza, participants were divided into teams of four or five by the Watson staff and sent out into the Loop with their question lists to begin hunting. The questions led members through sites such as the Chicago Cultural Center, Millennium Park, and City Hall. Sites that members might pass by on their daily commute became objects of detailed investigation as teams searched for correct answers. Watson Adventures protects the details of its hunts closely, rightly treating them like intellectual property, so we’re not at liberty to provide too many details here. But just to give a sense of the detail involved: how familiar are you with the gargoyles on the facade of the University Club?


Winning Team!

The Watson Adventures staff had also prepared some bonus tasks specifically for CFA Society Chicago that gave participants extra points for their scavenger hunt team score. In one task, participants got extra points for taking a photo of their team acting out “Community,” one of the five CFA Society Chicago organizational pillars. In another task, teams had to take a picture of themselves standing in front of a financial institution’s signage while pretending to flash trading pit signals. Scores between the participating teams were incredibly close, so bashful teams ignored these optional tasks at their own peril.

After an hour and a half of hunting, teams reassembled at Daley Plaza where Watson Adventures staff collected answer sheets and added up the scores. The winning team consisting of Mark Cichra, Caroline Frensko, Casey Hatch, and April Heitz, won by only a single point. CFA Society Chicago members thanked the Watson staff and expressed gratitude to each other for the team-building and camaraderie. Afterwards, participants gathered at nearby Randolph Tavern for drinks and conversation.

For more information about upcoming events organized by the CFA Social Advisory Group, check the Events page on the CFA Society Chicago website.

CFA Society Chicago Book Club:

SUPERPOWER: Three Choices for America’s Role in the World by Ian Bremmer

In a recent talk Ian Bremmer explained why he wrote this book now, an endeavor he had not contemplated in prior years stating “I think it is extremely important for all Americans to discuss our country’s role in the world, its choices, and make it a large part of the upcoming election.”    Bremmer feels that the United States is at a crossroads in its foreign policy, wandering between multiple ideologies which has weakened its position and left our allies and foes wondering what, if any commitments the USA is prepared to support.  As a guide Bremmer offers our future President three choices: Indispensable America, Money America and Independent America.  Each is expanded upon and discussed in the main body of the book after a brief synopsis of the current and recent history of the world’s foreign relations and America’s involvement.

Bremmer begins by giving a general outline of questions for the reader to consider as one weighs the three options and includes the topics: Freedom is? America is? China is? America’s biggest problem in the Middle East is? What are the USA’s spy capabilities? What are the risks? What is the primary responsibility of the president? What should America look like in 2050?  He uses this outline to help readers shape their own views and then benchmark those views against his three options described below:

  • Indispensable America: “Argues that only America can define the values on which global stability increasingly depends.  In today’s interdependent, hyperconnected world, a turn inward would undermine America’s own security and prosperity.  We will never live in a stable world while others are denied their most basic freedoms – from China to Russia to the Middle East and beyond.”  Since America is the only country that is capable of utilizing its vast resources to underwrite global security and support a general prosperity, it is our duty to help all democratic minded people who support human rights through military campaigns globally.  It is through our defense of our values that we can accomplish a peaceful world, and any retreat would subject millions (if not billions) of individuals to pain and suffering under the hands of maniacal dictators and cultures bent on domination and control.  It is America’s duty to free the world, and we as a nation must not only project strength but use our strength as needed.  This option calls for an expansion of military and economic aid throughout the world.  Pulling back fails to recognize the interconnectedness of the world, and America’s need for a stable world for economic growth.
  • Moneyball America:  This option “acknowledges that Washington cannot meet every international challenge.  With clear-eyed assessment of USA strengths and limitations, we must look beyond empty arguments over exceptionalism and American values.  The priorities must be to focus on opportunities and to defend U.S. interests where they are threatened.”  This option states that the U.S cannot be everywhere and do everything globally.  The next president will have to weigh each challenge, doing a cost benefit analysis on America’s role and decide which areas are worth America’s involvement and which are situations where the U.S. is simply overspending for the return received by both America and the world.  In order to do this correctly, a well thought out and consistent message and action plan must be accomplished.  If the U.S. is not clear when it will get involved and when it will not, the world will be left in confusion as to our intentions and commitments.
  • Independent America: This option “asserts that it is time for America to declare independence from the responsibility to solve other people’s problems.  Instead, Americans should lead by example – in part by investing in the country’s vast untapped potential.”  This argument is based on the belief that America’s history of foreign involvement recently has not benefited the world, and has left our own country in decay.  This option allows for a massive decrease in military and foreign aid that should be invested in America through: rebuilding our public infrastructure, investing in American education, increasing our care to our brave veterans, decreasing taxes, and getting our own financial position under control.  Bremmer recognizes this cannot be done immediately, but should be done gradually so as our allies can prepare their own defenses to face future challenges.  The next president should send a clear message that we are going independent and that the world will need to take a much bigger role in helping the oppressed and realize the U.S. is not going to be the policeman of the world into the future.

Bremmer leads the reader through the three choices, and offers a fourth which is “Question Mark America” which he totally dismisses.  This is the America which we are, going back and forth between the three options mattering on political polls and global sentiment.  He openly criticizes our current and near history policies, and calls for a clear solution and hopes that all Americans will force the presidential candidates to be coherent and specific on their foreign policy in the upcoming election.

The author does choose an option and defends his position – we will not disclose the final chapters so as not to spoil the ending.  However the strength of the book is not Bremmer’s own conclusion but that it is well constructed for all readers to really contemplate the current policy, the options and reach one’s own conclusion.  Many members began with one view but were slowly swayed one way or the other as they read this thoughtful treatise, remarking that the book contained many compelling and thought provoking ideas.

As a group we felt the book was an accurate snapshot of world events, and provided an excellent event synthesis on recent historical events.   Although a few indicated they began as a supporter of Indispensable America, after reading the arguments however, the group mainly felt the rest of the world needed to provide further global support and the U.S. was carrying too much of the burden.  In general it was felt that the world needed to step up their involvement in global policies and they needed to be more independent in their own defense structures.  We discussed in detail what we felt were the three major “hotspots” of the world namely the Middle East, Korean Peninsular and Eastern Europe.  Although we concluded it was impossible to serve as policeman to the entire world, the group in general thought it would be too dangerous to completely remove our commitments to these three areas.  Thus, the group in general thought Moneyball was the ultimate solution, although many agreed that the U.S. was not very good at deciding on the fly which was the best time and place for engagement.  In order for Moneyball to work a deep discussion is needed by our political structure to set up clear and decisive guidelines so our allies are fully aware of our intentions.  We also recognized the limitations to this strategy given the changing and dysfunctional environment in Washington at the present time.

There was also support for Independent America, given a long lead time for our Allies to “step up” their capabilities, but most thought the world would become too dangerous if we pulled back entirely and the ultimate result would provide a greater instability to world economic and political order.  We also discussed the fact that there may be alternatives to these three options including the idea presented to pull back but give implicit assumption guarantees to several of our allies in the crossfire such as South Korea, Baltic States and Israel.  Many also felt that pulling back was a hard decision when so many are suffering; can America sit by while many die to ruthless, uncivilized factions?  Simply withdrawing may be too repugnant for many, but who is willing to send their sons and daughters to sacrifice for these countries?  The question is difficult and the answer more so, but these are the thoughts of the reader who chooses to engage in Ian Bremmer’s world.

Lastly, it was noted that one entity was glaringly omitted from the book (although one brief mention did occur but was minor) – the United Nations.


Upcoming Schedule:


September 15, 2015: The New Cold War? Religious Nationalism Confronts the Secular State by Mark Juergensmeyer

October 20, 2015: The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies by Erik Brynjolfsson and Andrew McAfee

November 17, 2015: No Ordinary Disruption: The Four Global Forces Breaking All the Trends by Richard Dobbs, James Manyika, Jonathan Woetzel

December 15, 2015: TBD



To sign up for a future book club event, please click here:

Chemical Footprint: Screening Stocks for Chemicals of Concern

Chemicals are in virtually every product we buy from clothing, cosmetics, furniture, shampoo, fragrances, and building products to the food we eat and, of course, the pharmaceuticals used to treat illnesses. In short, life as we know it would not exist without chemicals.

Yet, chemicals also can be harmful and pose risks to human health depending upon their nature and the amount of time we’re exposed to them. So as a consumer, investor or business executive, it’s critical to understand your exposure to “chemicals of concern.”

Chemicals of Concern

Across the world, various regulatory, industry and government agencies have established lists of chemicals of concern. Any chemical that can potentially cause harm can be considered hazardous. However, certain chemicals can persist in the environment (air, water, land, plants and animals), build up in animal tissues and be toxic—causing different types of harm ranging from mild skin irritations to cancer.

Chemicals of high concern (CoHCs), as defined under the California Candidate Chemical List, include:

  • Carcinogens, mutagens or reproductive toxins (CMR)
  • Persistent bioaccumulative and toxic substances (PBT)
  • Other chemicals for which there is scientific evidence of probable serious effects on human health or the environment
  • A chemical whose breakdown products result in a CoHC that meets any of the above criteria

Sounds complicated but extremely important, right? Absolutely, socially responsible investors recognize that the improper use of chemicals can cause materially adverse investment performance and even greater harm to society. Therefore, it’s important that your investment manager conduct a broad screening for chemicals of concern when selecting stocks for your portfolio. Let’s look at a real-world example.

Lumber Liquidators (LL) – Linked to Health and Safety Violations

On March 1, 2015, Anderson Cooper, CBS News correspondent, reported on 60 Minutes that the laminate flooring sold by Lumber Liquidators (LL) may fail to meet health and safety standards because it contained high levels offormaldehyde, a known cancer causing chemical. As shown below, the stock price fell sharply just before and immediately following the report—then down 72% since the start of the year.

Source: Wall Street Journal Online

What went wrong?  Allegedly, it appears that Lumber Liquidators failed to properly control its supply chain by sourcing lower-cost, formaldehyde-tainted laminate flooring manufactured overseas. The flooring was tested by 3 independent labs and failed to meet California formaldehyde emissions standards (CARB-2) with levels, on average, six or seven times higher than allowed and in some cases as high as twenty times higher than allowed.

What were the repercussions? Lumber Liquidator’s CEO, Robert Lynch, resigned on June 16, 2015, and the company announced it would discontinue the sale of the laminate flooring manufactured overseas. Now, the company faces a growing number of product liability and securities lawsuits including allegations that its directors breached their fiduciary duties by failing to properly oversee the laminate flooring manufactured overseas.

This story offers an interesting case study on the importance of Socially Responsible Investing (SRI) and the value of careful environmental, social and governance (ESG) screening. Here are a couple of key takeaways:

I. Watch the Profit Margins  – 60 Minutes reported that Whitney Tilson, a hedge fund manager, correctly identified that Lumber Liquidators had doubled its profit margins in just two years. An unusual gain in a commodity business. These gains should have led more analysts to question the sustainability of the increased profits and the underlying business drivers.

II. Don’t forget the “S” in ESG – Some key social factors that can have a material impact on the value of a stock include (1) customer satisfaction (2) product safety and liability (3) supply chain management and (4) occupational health and safety.

In this case, Lumber Liquidators frequently advertised images of children playing on new hardwood and laminate flooring. Unfortunately, due to their size, children are also the most likely to first show symptoms of exposure to harmful chemicals. So, the risks of providing an unsafe product, used by children and in the home, ultimately destroyed customer satisfaction and caused homeowners to immediately rip the flooring out. Responsible investors should evaluate if the supply chain is sustainable and provides occupational health and safety to its workers.

Sustainable Investing: The ESG Approach

A sustainable approach to investing incorporates the analysis of material, non-financial ESG factors into the investment decision-making process and helps determine the final selection of securities for your portfolio. Analyzing material ESG factors ultimately helps investors rank order stocks before making final investment decisions.

Start with the Chemicals of Concern by Industry

When screening prospective investments, it’s helpful to start by identifying the chemicals of concern used in the industry you’re evaluating. Then determine the level of revenues from products containing those substances and explore the firm’s processes and controls for managing its chemicals. Look for information from industry, regulatory and government sources such as:

Benchmark and Rank Order Your Investments

After you’ve gained a broad perspective on the industry, it’s time to collect the sustainability metrics. In the Household and Personal Products industry, for example, the Sustainable Accounting Standards Board (SASB) suggests the following four metrics regarding chemicals of concern under its Product Environmental, Health and Safety Performance topic:

  1. Revenues from products that contain REACH substances of very high concern (SVHC) (Metric CN0602-05)
  2. Revenue from products that contain substances on the California DTSC Candidate Chemicals List. (Metric CN0602-06)
  3. Discussion of process to identify and manage emerging materials and chemicals of concern. (Metric CN0602-07)
  4. Revenues from products designed with green chemistry principals (Metric CN0602-08)

Ultimately, we’re trying to identify the firm’s “chemical footprint.” To that end, the Chemical Footprint Project (CFP) Assessment Tool (released on June 19, 2015) also provides a good resource for publicly benchmarking chemical use and management. It’s backed by over $1.1 trillion in purchasing and investment power with signatories that include Aviva Investors, BNP Paribas IP, Boston Common Asset Management, Calvert Investments, Miller/Howard InvestmentsTrillium Asset Management, Zevin Asset Management, Dignity Health, Kaiser Permanente, Staples, Target and many others.

In the final analysis, we’re looking for best-in-class performers and screening out firms with significant risks. In the long-term, integrating ESG analysis into the investment decision-making process will help identify companies with business models that are more sustainable, socially responsible and profitable.

Networking on the Green


The long, proud history of the CFA Society of Chicago, founded in 1925, was just barely preceded by the founding of Ruth Lake Country Club in 1922.  Nearly 100 years later, the two entities came together for an exceptional day of golf.

On August 3rd, more than 50 of the Society’s finest golfers and their guests descended on Ruth Lake to enjoy a fine time of fellowship and competition on one of the area’s premier country club courses.  The first nine holes were originally designed and built by David Foulis in 1922 with the second nine completed in 1923 to round out the 18 hole layout, creating a  fair but demanding track.  While the original design stood the test of time for over 80 years, an Arthur Hills redesign in 2005 brought it up to a higher standard of excellence.

The day’s events began with the group spending some timeDSC_2111 loosening up on the driving range and getting a feel for the glass-like putting greens.  At the same time, everyone was free to indulge in the full buffet lunch which was highlighted by bacon bratwurst, a selection of sandwiches, salads, and an assortment beverages.  After lunch, the participants were directed to their carts and sent out to their starting holes for the day’s golf.

As far as this writer’s round of golf went, the weather wasDSC_2113 fantastic!  Certainly all of the participants played both good and bad shots, had some punch shots fly straight through the trees, and others that were stymied by those same trees.  The putting greens were so quick that missed tap-ins could roll several feet past the hole, but certainly all would agree that they ran true for well-struck putts.  Overall, the course was in fantastic shape and provided a great test for all aspects of the competitor’s games.

After playing the course, the group gathered in the Club’s dining room for drinks and dinner.  As waiters provided drink service, a buffet was again laid out.  The dinner version offered various salads, sides, a mix of fish and chicken dishes, and a beef carving station.  This allowed time for the group to meet new friends, discuss the day’s play, provide recommendations for must-see courses in the area, and to potentially foster some new business relationships.

While the diners enjoyed their meals including delicious cake for dessert, Kim Augustyn presented awards and gift packages to the winners of the long drive, closest to the pin, and net team score contests.  We’d like to congratulate Thomas Campbell of Neil, Gerber & Eisenberg LLP for hitting his shot to 57” on the par-3 14th hole and Erik Kratz of Mid-Continental Capital for crushing his drive long and straight to win the long drive contest.  Jason Loy and Anthony Doughty of KPMG and Philip Figal and Scott Cosentine of Ashland Partners combined to shoot an incredible net 51 score to pick up the team honors.

Of course, we would also like to send special thanks to our sponsors for their generous support!

  • Eagle sponsor: Principal Funds Distributor, Inc.
  • Par sponsors: Allstate Investments, D3 Financial Counselors, LLC, ETF Managers Group, RBC Global Asset Management, and RiverNorth

With the 11th Annual CFA Society of Chicago Golf Outing in the books, all the participants will surely look back to remember a great Monday out of the office and will be looking forward to seeing what other outstanding area course will serve as host to next year’s event.

CFA Society Chicago Book Club:

On Saudi Arabia by Karen Elliott House

The CFA Society Chicago Book Club met July 21st for a lively discussion of On Saudi Arabia: Its People, Past, Religion, Fault Lines – and Future by Karen Elliott House.  The book is a fascinating look at the perspectives and interests propelling Saudi society and we were all surprised at how little we knew of this important trading partner and regional power including the following surprising facts:

  • 60% of the population is under 20 years old0307272168-195
  • 40% unemployment among 20- to 24-year-olds
  • 90% of private sector jobs are held by foreign workers
  • Individual initiative and risk-taking are frowned upon
  • Cinemas, music, men and women shaking hands, and books on Saudi Arabia are all forbidden
  • Saudis aren’t interest in democracy: seen by some as forbidden under Islam and by others as chaotic

The author conducts probing interviews with princes and religious leaders, stays in the home of a devout Muslim family, discusses the future with teenagers and college kids, and explores criminal behavior with ex-convicts.  She shows how the Saudi royal family uses religion and oil wealth as “opium of the people” to buttress their authority and maintain stability, but serious internal challenges are threatening the status quo.  Easy access to information tops the list.  Saudis are more informed and connected via social media and cable news and as a result are demanding transparency and fairness from government.  They also more openly question the royal family’s lavish lifestyle, which is in stark contrast to the conservative Islamic principles they advocate.  Meanwhile divisions among Saudis along tribal, religious, gender, reformist/traditionalist lines are increasing social tensions.  When the book was published in 2011 the Arab Spring was in full effect, fueled by these same internal dynamics.  This is still seen as a serious threat to the monarchy.

Saudi Arabia’s biggest external threat is Iran and its desire to expand influence in the region.  The Saudi monarchy has positioned itself as the leader of all Islam because the two holiest Muslim sites, Mecca and Medina, are in Saudi Arabia.  To an ambitious Iran these might be tempting to capture.  Increased Iranian prosperity following this year’s negotiated nuclear agreement could make them even more viable targets.  Add to that the increased competition in global oil production from fracking and alternative energy sources and its clear Saudi Arabia, while still strong, has some crucial challenges to address.

We debated various paths forward but ultimately agreed Saudi Arabia faces an unclear and possibly explosive future.  Resolving the poor education system was heavily discussed, since it generally fails to produce graduates with marketable skills and critical thinking ability.  But government corruption, dependence on royal favors and hand-outs hinders a productive working class.  Saudi men are reluctant to take jobs they see as beneath them.  Saudi women are largely sidelined, comprising a mere 12% of the workforce even though they increasingly educated and motivated.  Women are restricted to working only with other women, and often seek “acceptable” teaching or medical positions.  There’s a growing demand among women to lead more fulfilling lives, but many defend the status quo and feel it’s inseparable from their Islamic beliefs.  Women’s rights have become a proxy war between progressives and conservatives.  We also compared Saudi Arabia’s economic prospects to Russian and Chinese models, but its social code and wealth structure are just too different to be relatable.

Royal succession may offer a glimpse at Saudi Arabia’s future.  After his crowning earlier this year, King Salman made 29-year-old Prince Mohammed bin Salman deputy crown prince and concentrated unusually large responsibilities with him.  The prince now heads the state oil monopoly, the public investment company, ministry of defense, and leads the air war in Yemen.  This is shocking for a country that has stayed unified for decades by sharing positions among the royal family.  If this is any indication of its future, Saudi Arabia might become increasingly assertive in the region while enforcing religious conservatism internally.  We were also surprised that Saudis are generally not interested in gaining democratic freedoms.  The country is more a collection of tribes and Islamic factions than a unified state, and Saudis see a need for strong rulers to prevent internal wars.  Democracy is also seen by some as forbidden by Islam because elected leaders promise what they don’t have and praise themselves – both are Islamic taboos.

On Saudi Arabia offered a valuable look at the many layers of Saudi society and the challenges it faces.  It was fascinating to learn about this country that’s so important in the region and the world.


Upcoming Schedule:

August 18, 2015: “Superpower: Three Choices for America’s Role in the World” by Ian Bremmer

*NOTE: Author Douglas Sisterson is attending the PDDARI meeting which takes place just before the book club meeting on 8/18. He will be discussing his book “How to Change Minds About Our changing climate”.

September 15, 2015: “The New Cold War? Religious Nationalism Confronts the Secular State” by Mark Juergensmeyer

October 20, 2015: “The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies” by Erik Brynjolfsson and Andrew McAfee

November 17, 2015: TBD


To sign up for a future book club event, please click here: