The Harvester - Spring 2013

“THE ATTACKS UPON THE COURT ARE MERELY AN EXPRESSION OF THE UNREST THAT SEEMS TO WONDER VAGUELY WHETHER LAW AND ORDER PAY. WHEN THE IGNORANT ARE TAUGHT TO DOUBT, THEY DO NOT KNOW WHAT THEY SAFELY MAY BELIEVE.”
– OLIVER WENDELL HOLMES, JR.

One of the most important factors for investors over the years has been the rule of law. The world of finance changed dramatically in 1600 when Britain allowed the creation of the first corporation called British East India Corporation. Prior to the establishment of this entity, individuals were personally liable for the failure of any business. The benefit to establishing the corporation was the limited liability it afforded its shareholders. In other words, the most a shareholder could lose was the amount of money the shareholder invested in the corporation. Creditors of the Corporation were not permitted to hold the shareholders of the Corporation personally liable for the debts of the Corporation. This change in the law was one of the most significant changes for the growth of capital in the world.

What is equally as important is that the law – or the rules of the game – does not change abruptly. This is a lesson that should be heeded as the Eurozone fumbles its way through its crisis. The problem with Cyprus is not that big depositors will lose 60% of their deposits. The problem was the announcement to take 6.7% of deposits under 100,000 Euro. Why is this significant? Because there is a bank guarantee of 100,000 Euro per depositor that protects those deposits – similar to FDIC insurance here in the United States. The “elite” geniuses thought it was a good idea to change the rules of the game in the middle of the game. How can depositors anywhere in Europe feel secure with their money in the bank after this incident? Politicians that change the rules of the game in the middle of the game only make things worse. Unfortunately, this is not the first time this has happened in Europe.

Shortly after World War I, both Austria and Germany suffered severe economic crisis’ that caused major devaluations of both currencies. To combat this, Austria, in 1921, passed a bill that confiscated 20% of people’s capital – including property, shares, bank accounts and luxuries. The ramifications of this bill were devastating. As quoted from the book When Money Dies – the nightmare of deficit spending, devaluation, and hyperinflation in Weimer Germany, – “A grave psychological mistake was committed by the embargo on the removing of 20% of bank deposits, because the public, especially the peasants, thereafter became averse to confiding their savings to any financial institutions and hoarded them at home to the consequent dearth of the currency”. The subsequent result was a collapse of the economy as inflation grew at a 98% rate per month – in 1923!

In 1992, Italy’s Premier Giulano Amato reached into every bank account and took six Lira for every 1,000 (.6% of assets) Lira of Italian bank deposits. This “solidarity” measure was done to shore up Italy’s finances. How do you think the Italians that lived through the 1992 confiscation are feeling after what has happened in Cyprus? Their first thought is to get their money out of any financial institution.

Problems in the US

We do not believe a “confiscation” tax on bank accounts or assets in the United States is going to occur anytime soon. However, what is happening in Cyprus – and the entire Eurozone – should be a wakeup call for us if we don’t address our fiscal problems. Below is a chart from a recent Barron’s article that shows our demographic problem as more than 10,000 new baby boomers apply for Social Security each day. Can it occur here in the U.S.? Yes, if the rule of law is thrown out for expediency.

Changing the rule of law in the GM bankruptcy case for expediency purposes overturned years of precedent in that workers and retirees were given preferential treatment over secured bond holders. Judge Robert Gerber stated, ”When I approved the (bankruptcy) sale agreement and entered the sale approval order I mistakenly thought that I was merely saving GM, the supply chain, and about a million jobs.” Today, Judge Gerber is considering reopening the case because of a lawsuit by some of those creditors. His decision in this case could have repercussions as dramatic as Britain’s decision to establish corporations. If the case is reopened and creditors receive their money – which has been bankruptcy law for over 200 years – it will be good for our economy in the long run. If not, it could become precedent and have negative ramifications, especially on two bankruptcies now pending in Stockton, CA and Patriot Coal.

Stockton, California has filed for bankruptcy protection and the City’s plan is to fully fund the retirement obligations to its employees to the detriment of its bond holders. If the GM bankruptcy decision is upheld, it likely will be used as precedent in support of Stockton’s position. In West Virginia, Patriot Coal has also recently filed for bankruptcy protection citing unsustainable legacy costs and a downturn in the coal market as reasons for its problems. The company is seeking to modify its collective bargaining agreement to allow for the creation of a trust fund of about $300 million from future profits. This trust fund will fund retiree health benefits that currently are estimated at $1.6 billion. The two senators from West Virginia are advocating for a bill in Congress requiring that the Federal Government fully fund the benefits for the retirees. We find it ironic that the politicians that destroyed the coal industry over the last few years by overregulating it for the sake of green energy are now seeking to have the rest of the country pay for that decision. No decision has been handed down by the U.S. Bankruptcy Court at this time. The GM case may again be used as an example for the court to fully fund the health care benefits at the expense of senior creditors. That would be a blow to the capital markets.

By overturning bankruptcy laws, the courts will significantly increase financial costs throughout the country. Many municipal bonds are backed by the revenue from the project for which the bonds are issued. Because these bonds are deemed “more secure” for the investor, they have a lower interest rate. If the City of Stockton gets its way in its bankruptcy case, these municipal bonds will not be as secure as they once were. That would mean higher interest rates – and higher costs – for all municipalities.

This is a slippery slope for courts to go down. In our opinion, it would have been better for the government to guarantee funds for GM’s creditors than overturn the rule of law. Europe would be much better off if it didn’t suggest going after deposits under 100,000 Euro. Once the rule of law is broken, investor’s confidence is eroded in capital markets. In turn, investor’s will demand a higher rate of return in order to take on additional risk in the market. Changing the rules of the game in the middle of the game is never a good thing.

New team member

We are happy to announce the newest addition to THOR, Jimmy Stechschulte. Jimmy graduated from The University of Dayton in May 2012 with an MBA. Prior to receiving his MBA, Jimmy received a bachelor degree in Finance and Accounting from UD. Jimmy is originally from Minster, Ohio, a small town located one hour north of Dayton. Jimmy has a passion for the investment business and a thirst for knowledge in the global markets. In his free time, Jimmy enjoys golf, basketball, reading, music and spending time with family and friends.