Building a New Investment Strategy Model, Comment #1

During recent Congressional testimony, the CEO of Goldman Sachs was asked about how the current charges against Goldman had altered their internal risk management. In essence, how could the situation inform the firm’s “best practices.”

Indeed, this is an important question for investors who bought these securities and similar securities to ask as well. In the future, it would be nice if Wall Street did not try to engage in transactions that were harmful to the real economy. At the same time, if no investor had been willing to invest in Goldman’s mortgage transactions, or in financing a destructive housing bubble and related derivatives transactions, things would have turned out very differently for our countries, for investors and for the beneficiaries they represent.

So, what can an investment strategist do now and in the future that would help protect the assets they manage against the kind of risks and losses that we have experienced?

I would like to do a series of posts on this topic. To start, I am going to republish several pieces from our archives that inform the discussion.

First, a letter I sent to the New York Times on March 7, 1999 that described the extraordinary contradictions between assumptions behind investments purchased by pension funds. For example, we were watching funds invest in stocks that was financing jobs going abroad, at the same time they were financing a housing bubble that would certainly burst when the income of the homeowners started to fall from shifting the jobs abroad. They were buying government bonds that was financing a war on drugs that was uneconomic, particularly when the rising cost of prisons was considered. And of course the movement of jobs abroad increased the drug and prison costs. However, they were also buying stocks in private prisons, which meant that their profits depended on more people failing.

It seemed as though their investment strategy was bound to become the victim of multiple personality disorder, particular if the day should come when the continual decreases in systemwide productivity embedded in the model could not be covered over with continual rises in government spending financed with continual rises in government borrowing and monetary printing presses.


March 7, 1999

Letters to the Editor
New York Times

Ladies and Gentlemen:

Thank you for Tim Egan’s article on prisons. It was an excellent summary of the growth in the US prison population over the last two decades. A welcome follow up might be an exploration on how the money works on prisons.

The federal government has promoted mandatory sentences and taken other steps that will increase the overall prison population to approximately 3 million Americans as recently legislated policies finish working their way through the sentencing system. This means that approximately 10-15 million Americans will be under the jurisdiction of the criminal justice system from arrest, to indictment, to trial, to prison, to probation and parole.

The enactment of legislation ensuring the growth of prisons and prison populations has been a bipartisan effort. Republicans and Democrats alike appear to have found one area where we can build consensus for substantial growth in government budgets, staffing levels and media attention. Indeed, during this period, the number of federal agencies with police powers has grown to over 50, approximately 10% of the American enforcement bureaucracy. This is further encouraged by federal laws permitting confiscation of assets such as homes, cars, bank accounts, cash, businesses and personal property that can be used to fund federal, state and local enforcement budgets.

One way to look at the financial issues involved is to view them from the vantage point of the portfolio strategists of the large mutual funds. We have approximately 250-280 million people in America. The question from a portfolio strategist standpoint is what productive value will each one be creating in companies and communities and how does that translate into flow of funds that then translate into equity values and bond risk.

The prison companies are marketing one vision of America with their prison and prisoner growth rates, while the consumer companies are marketing another. The two are not compatible. CCA’s assumptions regarding the growth in arrests and incarceration can not be true if Fannie Mae’s, Freddie Mac’s and Sallie Mae’s assumptions about homeownership and college education rates are. We, the people, cannot refinance our mortgages or buy homes or raise our children and send them to college if we are in jail. Meantime, the municipal debt market is also facing conflicting positions. If prison bonds are a good investment, then some general obligation bonds may be in trouble. We, the taxpayers, can not support the debt: we are no longer taxpayers. We have become prisoners. Whatever we are generating in prison labor, it is certainly not enough to pay for the $154,000 per prisoner per year costs indicated for the full system by the General Accounting Office.

It would be very illuminating to get the rating agencies and the ten largest mutual funds together in one room for an investor roundtable to discuss pricing levels on the investment of our savings that is internal to their portfolios and ratings. We would compare equity valuations and growth rates of:

• companies who make money from the American people losing productivity
• companies who make money from helping the American people grow more knowledgeable and productive.

We are investing in two different visions that can not both come true.

We could then calculate which was going to succeed, and what the integrated pricing level would be. Better yet, what could happen that would make the most money for the investment community. The question is which vision is best for we, the equity investors of America? And why are investors assuming both can or will win as they price their stocks and bonds?

It is critical to look at prison policy from the standpoint of maximizing return on equity investment. It would be a terrible thing, while I can no longer pay taxes or buy a house or send my son to college because I am in prison, if my vested pension benefits were wiped out by the time I re-entered society. It is bad enough that my life savings are being invested in companies that make money from promoting that me and my family should be arrested and incarcerated. It would be worse if I and my family were broke because companies that make money from loss of productivity turned out to also be a bad investment.

Such a roundtable might make for a great New York Times article. If you are willing to take it on, Solari would be happy to assist your staff by contributing background analytics on how the money works in prisons.

Sincerely Yours,
Catherine Austin Fitts
Solari, Inc.