In the classic 1988 film Bull Durham, the frustrated manager throws a staged tirade in order to turn his team around, a tirade which includes the immortal lines:
"This is a simple game. You throw the ball. You hit the ball. You catch the ball."
In spite of all the mystique that for some reason surrounds the world of finance (including the numinous world of "high finance"), our opinion is that finance is a simple game as well:
"You invest capital. You hope to get your original amount back. You hope to get something in addition to that original amount to compensate you for your trouble and the use of your capital."
That's it. Not quite as eloquent as the manager of the Durham Bulls, but simple nonetheless.
If the arrangement is a loan, you hope to get back your principal plus interest. If the arrangement involves equity in a business, you hope that the value of your equity stake grows enough to return your original investment plus some capital gains. You may also get dividends. If the entity asking for the capital is well-connected politically, it might be able to offer you interest that is not subject to taxation.
Other more complex capital structures might involve debt that returns your principal plus interest plus a chance to convert into equity. There are really no limits to the way the investment can be structured -- theoretically you could craft a deal that would promise to return your principal plus one pizza a month for twenty years, if you really wanted to.
However, if you decide to enter into this business and you want to have any hope of seeing your original amount come back to you, let alone anything extra, you might want to do a little bit of analysis of the entity to whom you are giving your money. After all, if you walk into a bank and ask them for a million dollars in financing, they won't usually just hand it over to you -- they will typically want to ask you a few questions about your income, your other debts, your credit history, etc. Investors would be wise to do the same before they get into the business of financing.
That's why at Taylor Frigon Capital Management, when investing capital on behalf of our clients, we exercise extreme caution with regard to investment in municipal bonds. Not only do we feel that many of them have terrible answers when it comes to their income, other debts, and credit history, but there have also been examples of municipalities being slightly less than forthright in their answers to those questions (in other words, making their answers sound better than the actual situation would suggest is the case).
Recently, the US Securities and Exchange Commission charged two borrowers with securities fraud for allegedly deceiving those considering the loan of capital to them. Those borrowers were municipalities: Harrisburg, Pennsylvania, and South Miami, Florida. As municipalities, they borrow money by issuing municipal bonds. States in the US also borrow money by issuing municipal bonds (when the federal government borrows money, they issue Treasury bills, notes and bonds).
In an article entitled "The Many Ways Cities Cook their Bond Books," Steve Malanga of the Wall Street Journal explains that the SEC has previously charged states with making "material omissions" and "false statements" in their municipal bond documents, including the state of New Jersey in 2010 and the state of Illinois in March of this year. The article explains that:
With Harrisburg, however, the SEC has gone further and charged the city government with "securities fraud for its misleading public statements when its financial condition was deteriorating and financial information available to municipal bond investors was either incomplete or outdated." The SEC says this is the first time the regulator has "charged a municipality for misleading statements made outside of its securities disclosure documents."
The article explains that such fraudulent activity in misleading potential and actual investors is nothing new in the municipal bond market. It notes that when Stockton, California, filed for bankruptcy, the city's new financial managers found evidence that Stockton had been hiding "significant costs, including the real cost of employee compensation and retirement obligations," and that after San Bernardino, California, filed for bankruptcy, some observers alleged finding evidence that the city "had been filing inaccurate financial records for nearly 16 years." Just read that last quotation again slowly in order to let it sink in.
All of this is related to the issue that we have called "The question of our time," which is the fact that "retirement obligations" (as in pensions for government employees) and other government benefits (including health insurance programs) have been promised far in excess of what government incomes can sustain, not just in US cities and states but in fact all over the world (Japan and Europe are two other examples recently in the news).
Those who decide to loan money to a government entity should conduct a thorough examination of such obligations and the income that is supposed to be supporting those obligations, before committing capital. As the article points out, however, it is always more difficult to do that when the entity asking for the loan is deliberately falsifying their books.
In the end, financing really is a very simple business. If you intend to offer your capital to some entity, in the expectation of getting it back some day with "something extra" (whether interest payments, dividends, capital gains, or some combination), it would be wise to consider the potential for growth of that entity's incomes and financial obligations.
