Contango, Backwardation and all that (Forbes, Bloomberg Businessweek)

You Say Contango, I Say Problemo
Oct. 20 2010 - 9:21 am

By ETFCHANNEL.COM

There has been a lot of discussion lately around the words “contango” and “backwardation” as these terms relate to commodities ETFs. For futures traders, understanding these terms may be old hat, but for the rest of us, the concept can be confusing and foreign.

So, to explain contango, lets find some common ground where we can all relate: buying jugs of water at the supermarket.

In our world of make-believe, lets pretend a company is going to start a fund that you, as an investor can buy like a stock, to track the price of water over time. And, for the sake of our example, lets say that the fund will buy jugs of water near the beginning of each month, the supermarket will hold the jugs for the fund all month, and all jugs need to be re-sold by the fund before the end of the month, unless the fund wants to pick them up from the supermarket and use valuable storage space to house them (lets say that storage space would cost the fund a good amount of money to the point where the fund doesn’t consider this a viable option).

So, on January 1st, the fund buys as many jugs of water as it can afford, and sometime before midnight on January 31st, it sells all the jugs, and makes a deal with the supermarket that the supermarket will set aside more jugs for the fund on Feb 1 and hold them for the fund until February 28th.
Example #1 – On January 1 it costs $3 for a jug of water. As we approach the end of January, the fund can give the supermarket $3.25 to buy and store new water for them in February, but they first have to sell the $3 jugs they’re holding that they bought on Jan 1 to raise money for the February purchase and to make sure they don’t have to pay storage costs if they get caught owning the water jugs past Jan 31st.

So, the fund sells the $3 water jugs, and pays the supermarket now to buy and hold the jugs in February at $3.25 per jug.

What happened? The fund had to “roll forward” from the jugs they bought in January, into the deal where they paid more for the jugs of water for February and lost the difference in value. This is called contango. The steeper the price difference between the water they’re holding in January, and the right to buy new water in February, March, April and so on, the more deviation the fund will have from the actual price of water they’re tracking.

Example #2 – In January there’s going to be a massive hurricane. When the fund goes to sell its January water jugs, everyone wants water then and there. People are worried that they’re going to get stuck in their homes for a week with no fresh water.

However, the supermarket approaches the fund and says “We know we’re going to have a lot of extra water in February, March, April, etc. when this hurricane blows over. If you agree to pay us now for your February water, you can have it for $2 per jug.”

So, the fund goes ahead and sells their $3 water now, and turns around and pays the supermarket $2 for the February supply.

This is called “backwardation.” The fund is actually selling high and buying low.

These same principles apply to commodity exchange-traded funds and other funds.

Bloomberg Businessweek discussed this in an article called Amber Waves of Pain as it related to U.S. Oil Fund (USO), U.S. Natural Gas Fund (UNG), PowerShares DB Agriculture Fund (DBA) and others.

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Businesssweek Cover Story July 22, 2010, 5:00PM EST

Amber Waves of Pain
Lured by the idea of profiting from raw materials, investors put $277 billion into commodity ETFs and related securities by the end of 2009. Then they noticed a problem: When commodities go up, the commodity ETFs often don't

By Peter Robison, Asjylyn Loder and Alan Bjerga

Like so many investors in the spring of 2009, Gordon Wolf needed to dig out of a hole. A 68-year-old psychologist in Napa, Calif., Wolf was a buy-and-hold sort of guy, yet the nest egg he had entrusted to his broker at Merrill Lynch (MER) was suddenly down by more than 50 percent. The broker had invested much of it in a range of exchange-traded funds, or ETFs, a relatively new financial innovation that was replacing mutual funds in the hearts and portfolios of many investors.

An ETF, which can be bought or sold like a stock, attempts to track the price of a particular basket of assets—tech stocks, for instance, or high-yield bonds, or commodities ranging from wheat to gold to oil to natural gas. The commodity ETFs were supposed to offer a hedge against equity losses, but in the crash of 2008 everything fell in tandem. Now it was early 2009, and Wolf was watching oil fall to $34 a barrel. That had to be an opportunity, he figured, so he called his Merrill broker and asked about the U.S. Oil Fund (USO), an ETF designed to track the price of light, sweet crude. "This seems to be something good," Wolf told the broker, and had him buy about $10,000 of USO.

What happened next didn't make sense. Wolf watched oil go up as predicted, yet USO kept going down. In February 2009, for example, crude rose 7.4 percent while USO fell by 7.4 percent. What was going on? Wolf logged on to Seeking Alpha, a financial blog, and searched for USO. He found plenty of angry discussion about the fund—lots of people were losing lots of money, because thousands of American investors had seen the same sort of opportunity Wolf had. By the end of 2009, they had a record $277 billion invested in commodity ETFs and other securities linked to raw materials—a 50-fold jump from $5.5 billion a decade earlier, according to Barclays Capital. During that time, Wall Street had transformed the reputation of commodities from a hyper-volatile investment that can steal your shirt to a booster for battered portfolios, something that rose when stocks fell and hedged against inflation. People who would never think of buying a tanker of crude or a silo of wheat could now put both commodities in their 401(k)s. Suddenly everybody was a speculator.

And some were losing big. The commodity ETFs weren't living up to their hype, and the reason had to do with a word Wolf had never heard before. As he browsed the blogs, he says, "I'm seeing people talking about something called contango. Nobody would define it." Wolf called his broker and asked about contango. "I don't know what it is," he replied. He called his other broker, at Charles Schwab (SCHW). "He didn't know either," Wolf says. "He said he'd ask around." Weeks later, after Wolf educated himself, he fired his Merrill broker and pulled his money out. (Merrill and Schwab declined to comment.) By then he had lost $2,500 on USO. "If it wasn't a rigged game," he says, "I could figure it out. But it is a rigged game."

The Contango Trap
Contango is a word traders use to describe a specific market condition, when contracts for future delivery of a commodity are more expensive than near-term contracts for the same stuff. It is common in commodity markets, though as Wolf and other investors learned, it can spell doom for commodity ETFs. When the futures contracts that commodity funds own are about to expire, fund managers have to sell them and buy new ones; otherwise they would have to take delivery of billions of dollars' worth of raw materials. When they buy the more expensive contracts—more expensive thanks to contango—they lose money for their investors. Contango eats a fund's seed corn, chewing away its value.

Here's an example. The Standard & Poor's Goldman Sachs Commodity Index (S&P GSCI), which tracks 24 raw materials, is the basis for as much as $80 billion of investment. Managers of funds linked to the index, created by Goldman in 1991, have to buy their next-month futures contracts between the fifth and the ninth business day of each month. During that period in May 2010, fund managers sold contracts for June delivery of crude oil priced at $75.67 a barrel, on average, according to data compiled by Bloomberg. Managers replacing those futures with July contracts had to pay $79.68. After the roll period ended, the July contract fell back to $75.43. For each of the thousands of contracts, in other words, managers paid $4 for nothing—and the value of their funds dropped accordingly.

Contango isn't the only reason commodity ETFs make lousy buy-and-hold investments. Professional futures traders exploit the ETFs' monthly rolls to make easy profits at the little guy's expense. Unlike ETF managers, the professionals don't trade at set times. They can buy the next month ahead of the big programmed rolls to drive up the price, or sell before the ETF, pushing down the price investors get paid for expiring futures. The strategy is called "pre-rolling."

"I make a living off the dumb money," says Emil van Essen, founder of an eponymous commodity trading company in Chicago. Van Essen developed software that predicts and profits from pre-rolling. "These index funds get eaten alive by people like me," he says.

A look at 10 well-known funds based on commodity futures found that, since inception, all 10 have trailed the performance of their underlying raw materials, according to Bloomberg data. The biggest oil ETF, the U.S. Oil Fund, which Wolf bought and which now has $1.9 billion invested in it, has dropped 50 percent since it started in April 2006—even as crude oil climbed 11 percent. The $2.7 billion U.S. Natural Gas Fund (UNG), offered by the same company, has plummeted 85 percent since its launch in April 2007—more than double the 40 percent decline in natural gas. Deutsche Bank's (DB) PowerShares DB Agriculture Fund (DBA) has eked out a 3 percent total return since January 2007, while the weighted average of its commodity components has risen 19 percent. To be sure, those spot prices—reported on cable business channels and other outlets—set an unreachable benchmark. If investors try to match the spot market using ETFs, they can get killed by contango. If they dodge contango by buying physical commodities instead, they must pay heavy storage costs that can easily turn gains to losses.

The allure of commodity investment has hit even the most sophisticated investors. The California Public Employees' Retirement System, the largest public pension in the U.S., has lost almost 15 percent of an $842 million investment in commodity futures since 2007, according to its latest filings, depriving it of income at a time when it has sought taxpayer money to cover retiree benefits. It defends the investment as insurance that will pay off in the event of inflation.

Just as they did with subprime mortgage-backed securities, Wall Street banks are transferring wealth from their clients to their trading desks. "You walk into a casino, you expect to lose money," says Greg Forero, former director of commodities trading at UBS (UBS). "It's the same with these products. You're playing a game with a very high rake, a very high house advantage, and you're not the house."

Consumers Take a Hit
Selling commodity investments has long required training in the futures markets. Selling commodity ETFs doesn't, says Michael Frankfurter, managing director of Cervino Capital Management, a commodity trading adviser in Los Angeles. Turning commodity futures into securities unleashed a much larger sales force—stockbrokers selling a product many of them didn't understand, he says. Passive buy-and-hold investors at one point in mid-2008 held the equivalent of three years of production of soft red winter wheat. Wall Street's success in attracting those buyers boosted demand for futures contracts, which helped determine what consumers would pay for baked goods.

Wheat prices jumped 52 percent in early 2008, setting records before plunging again, and sugar more than doubled last year even as the economy slowed, forcing Reinwald's Bakery in Huntington, N.Y., to fire five of its 32 employees. "You try and budget to make money, but that's becoming impossible to predict," says owner Richard Reinwald, chairman of the Retail Bakers of America. Cocoa futures reached a 30-year high early this year because of speculators, according to Juergen Steinemann, chief executive officer of the world's largest maker of bulk chocolate, Zurich-based Barry Callebaut. At the airport, the new $25 charge for checking a suitcase exists partly because airlines have to set aside cash to hedge against sharper ups and downs in oil prices, says Bob Fornaro, CEO of AirTran Holdings. "This has been very, very good for Wall Street," he says.

Sponsors of commodity ETFs and similar investments—including Deutsche Bank, Barclays (BCS), and UBS—warn of the risks in their prospectuses. Those banks declined to comment, but defenders say it's unfair to single out returns over any specific time period. "Diversification doesn't mean you're always going to be up, but you spread the risk differently," says Kevin Rich, a former Deutsche Bank executive who developed the first futures-based commodity ETFs in the U.S.

Not every trader is comfortable with what Wall Street has done. Forero, 36, became director of commodities trading at UBS in 2007. A New Yorker whose father was Colombian consul to the U.S., he began his career at JPMorgan Securities, then worked a series of energy-trading jobs before landing at UBS's securities division in Stamford, Conn., where the Swiss bank operates one of the world's largest trading floors. UBS had bought Enron's energy desk, so Forero sat among veterans of the disgraced company.

UBS sold notes linked to futures and earned commissions handling the monthly roll for clients such as USO, Forero says, adding that he didn't do the roll himself. ("That was a different group," he says.) In January 2009, stung by subprime losses that forced a Swiss government bailout, UBS shut its energy desk. Forero and his wife had a newborn daughter and a $1.2 million Colonial in Norwalk, Conn. With no job, Forero holed up in his home office, sifting through data with a Hewlett-Packard (HPQ) scientific calculator. He became convinced that the products UBS had sold were hurting investors and disrupting supply and demand for basic commodities.

"I've always been a little naïve, and maybe I still am," he says. "But how can the government allow that? People in our industry talk about it—everybody knows about it. This has to come to light."

The Birth of an Idea
Bob Greer spent long days during the mid-1970s in the basement of a public library in Tulsa, going through rolls of microfilm. He painstakingly copied commodity prices onto yellow legal pads, then tallied them up on a handheld calculator—piecing together the first investable commodities index. An economist and mathematician with a Stanford University MBA, Greer had worked at a commodities brokerage in Dallas, where he got the idea that raw materials might belong in investment portfolios, alongside stocks and bonds.

Greer's work in the library basement led to the publication, in 1978, of his first article on buy-and-hold commodity investing in the Journal of Portfolio Management. "Conservative Commodities: A Key Inflation Hedge" outlined the benefits of passive, unleveraged, long-only bets on raw materials. The idea didn't catch on, and Greer went into commercial real estate. At the time, everyone knew someone who had gone broke betting on soybeans, or a gold bug who hoarded coins against catastrophe, he says. Commodity investing wasn't respectable. "People did not believe that the words 'commodity' and 'investment' belonged in the same sentence," says Greer, now 63 and an executive vice-president at Pimco in Newport Beach, Calif.

Greer had long since given up on his idea by 1991, when Goldman launched its benchmark commodity index and began selling swaps that tracked it to institutional investors. Two years later, Daiwa Securities hired him to create an index based on the one he had dreamed up in Tulsa. Commodities investing was catching on, and Greer says a breakthrough came when the tech bubble burst in 2000. By 2002, when the Standard & Poor's 500-stock index plunged 25 percent, investors were desperate for alternatives. That year, Pimco hired Greer to start its Commodity RealReturn Strategy Fund. The actively managed fund has returned more than 200 percent since its debut.

While Greer was launching his fund, a natural resources consultant in Australia, Graham Tuckwell, was developing the first commodity ETFs. Tuckwell had worked for Salomon Brothers, Credit Suisse (CS) First Boston, and Normandy Mining, Australia's largest gold producer; by 2002 he was working with the Australian Gold Council, looking for a way to encourage gold investing. An acquaintance mentioned an oddball product: wine securities. They were "funny little things," Tuckwell says, that allowed cases of a particular vintage to be traded on a stock exchange. He decided his fund would work the same way. Instead of cases of wine, the shares would be backed by gold bars stored in a vault.

Tuckwell's innovation, rolled out in 2003 and then called Gold Bullion Securities, soon became a hit, and in April 2004 a contact at Royal Dutch Shell (RDSA) approached him with a question: Could he do for oil what he had done for gold? "An oil refinery takes an enormous amount of working capital because you have all this crude oil sitting there," Tuckwell says. He went to Shell and pitched a product that would help the company make money from the crude it keeps in storage.

Backing the oil ETF shares with the physical commodity proved unwieldy. Gold was compact and easily stored in a vault; oil was in depots, pipelines, and tankers all over the world. Instead, Tuckwell's London firm, ETF Securities, entered into a swap agreement with Shell. Tuckwell used investors' money to buy contracts from Shell, and Shell gave them the same return as crude oil, based on the price of Brent crude futures. Since the oil ETF started trading in London in 2005, Brent has risen 30 percent; the fund has dropped 27 percent. The risks are clearly outlined in the prospectus, Tuckwell says, and anyone who doesn't understand the product first shouldn't buy it.

Banks used new academic research to pitch commodities as a safe way to diversify. In one 2004 presentation, Heather Shemilt, then a managing director and now a partner at Goldman, called the strategy "the portfolio enhancer." That same year two professors, Gary B. Gorton of the Wharton School and K. Geert Rouwenhorst of Yale University, published a paper, funded in part by AIG (AIG), which argued that an investment in a broad commodity index would have brought about the same return as stocks from 1959 to 2004, and would often rise when stocks fall. Under the crystal chandeliers of San Francisco's Palace Hotel in June 2005, Rouwenhorst presented his findings to more than 100 investment pros; Shemilt also appeared, alongside managers from Barclays and AIG. After the talk, many in the audience had the same question: How do I do this?

Barclays, Goldman, AIG, and other firms had developed ways to help them do it—several types of investments based on futures contracts, which had been used for almost 150 years to arrange the price and delivery of a given commodity at a specified place and date. These products remained the province of wealthy investors. In 2004, however, Deutsche Bank's Rich devised a commodity ETF that opened the door to retail investors when it launched two years later. There was an obstacle: The U.S. Commodity Futures Trading Commission, a regulatory board created in 1974 after a runup in grain prices, required buyers of certain commodity investments to sign a statement saying they understood the risks. The banks argued that it would be impossible to collect so many thousands of signatures for a product designed to trade like a stock. In 2005, Deutsche Bank lawyer Greg Collett, who had worked at the CFTC from 1998 to 1999, helped persuade the commission to waive the rule and let funds replace it with their prospectus. That would provide adequate warning, the CFTC concluded. Collett says he believed the fund "democratized" commodity investing.

Rich started attending National Grain & Feed Assn. conferences to introduce ETF investors to the traditional players, such as farmers and silo operators. One conference featured a boat ride up the Illinois River to visit a grain depot, giving Rich a chance to explain his new ETFs to old-school grain traders. "They were a bit suspicious," he says.

These days, the Wall Street banks are more like those grain traders than you might think. They have equipped themselves to take delivery of raw materials when they choose to, so they can wait for the commodity price to rise without having to roll contracts, giving them another advantage over ETF investors. Goldman owns a global network of aluminum warehouses. Morgan Stanley (MS) chartered more tankers than Chevron (CVX) last year, according to shipbroker Poten & Partners. And JPMorgan Chase (JPM) hired a supertanker to store heating oil off Malta last year, likely earning returns of better than 50 percent in six months, says oil economist Philip Verleger. "Many, many firms did this," he adds, explaining that ETF investors created this "profitable, risk-free arbitrage opportunity" when they plowed into commodities. Futures are bilateral; if someone's buying, someone else is selling. "And the only way to attract sellers is to offer them a bigger profit," Verleger says. "So, ironically, passive investors have been sowing the seeds of their own defeat"—and contributing to the contango that does in their funds.

Even the former Deutsche Bank lawyer who helped open the floodgates now says something has gone wrong. "Like most things on Wall Street, they have been over-marketed," Collett says. "The complications have been glossed over. I'm not sure the people marketing them even understand the complications, and that's a shame." Collett left Deutsche in 2008 and is pursuing a career as a stand-up comic in New York.

Poster Children
If you're going to serve as de facto spokesman for the commodity ETF industry, it probably helps to have played college rugby. John Hyland is the chief investment officer of U.S. Commodities Funds, the Alameda (Calif.) company that manages USO and its sister fund, U.S. Natural Gas. Majoring in political science at the University of California at Berkeley in the late 1970s, Hyland played the rugby position called hooker, which requires toughness and fancy footwork to jerk the ball out of the scrum. "My wife calls me the human battering ram," he says. For the past year he's been trying to keep his funds out of a regulatory pileup.

Hyland, 51, had never managed commodities before he joined U.S. Commodities in 2005. He had been in the investment business for 20 years—running portfolios and mutual funds—before he teamed up with U.S. Commodities CEO Nicholas Gerber. In 2006, as Gerber and Hyland were trying to win approval from the Securities & Exchange Commission for the U.S. Oil Fund, the fund's prospectus hit the desk of Dan McCabe, then CEO of Bear Hunter Structured Products, which was to be the fund's first market maker. McCabe recalls immediately spotting how traders would pick USO apart.

"Anybody who looked at it prior knew exactly what would happen," McCabe says. "From a trading side—and I spent most of my life trading—I would say, 'Wow, what a great opportunity.' "

After Hyland's oil and natural gas funds surged in 2008 and 2009, he found himself in the crosshairs of the Commodities Futures Trading Commission, which was holding hearings on energy speculation in the wake of $147-a-barrel oil. CFTC Chairman Gary Gensler began calling for limits on the number of energy contracts a single trader can hold. As Hyland's ETFs became poster children for the problem, Hyland became their most vocal advocate. At an ETF conference in Boca Raton, Fla., in January, he showed up with bottles of Merlot stamped with the company logo and the words "California Crude." The chances of pre-rolling his funds, he maintains, are "historically a 50-50 crapshoot"—a view many traders reject. His funds track daily moves in futures prices, he continues, because spot prices are impossible to capture unless you store fuel yourself. "I don't think the products are flawed," he says. "They do what they say they're supposed to do."

On Feb. 6, 2009—to cite one example—USO did what McCabe guessed it might. It gave traders an opportunity to profit at the expense of the fund's investors, McCabe says. With oil prices near their lowest in more than four years, long-term investors like Wolf had flocked to the fund; its monthly roll, taking place that day, had grown so large that it represented financial contracts for nearly 78 million barrels of oil, roughly four times the amount of oil the U.S. consumes in a single day. On Feb. 6, the price spread between expiring crude oil futures and those for the following month widened by $1.39 a barrel, or 30 percent, to $5.98. The price jump was so extreme that the CFTC announced an investigation within weeks, saying it "takes seriously issues surrounding price movements in our nation's vital energy markets."

In the midst of the price swing, according to an account released by the CFTC in April, a Morgan Stanley trader made a secret deal with a broker at UBS, acting on behalf of USO. Around noon, Morgan Stanley agreed to buy 33,110 of the fund's expiring March contracts and sell it April contracts, the CFTC said. The Morgan Stanley trader asked UBS to keep the trade quiet—a violation of New York Mercantile Exchange (Nymex) rules—until after the 2:30 p.m. close of trading that day.

The secret deal was breathtakingly large, equivalent to 12 percent of March futures on the Nymex. At the end of the day, USO and its investors lost because of the extreme contango: They could afford fewer of the more expensive April futures than they had in March, Forero says after analyzing Bloomberg data. Buying the same amount of oil would have cost $466 million more, he estimates. "You can either get screwed out of money or you can get screwed out of product," he says. "They had to pay more for effectively the same barrels."

The CFTC told the oil fund it may be held "vicariously liable" for UBS's actions, according to a March filing with the SEC. Hyland says he knew nothing about the deal. In April the CFTC ordered a $14 million civil fine for Morgan Stanley and $200,000 for UBS for failing to report the trade as required. The CFTC declined to explain how it arrived at the amounts or to disclose Morgan Stanley's profit. UBS declined comment. "Morgan Stanley fully cooperated with the CFTC and is pleased to have reached a resolution with our regulator," says company spokeswoman Jennifer Sala. "This matter concerned an isolated request by a former Morgan Stanley trader."

Without knowing Morgan Stanley's trades, Hyland says, it's hard to determine whether the bank's actions harmed investors. "The best that you can do as the provider of investment products is lay out, in as much detail as you think people can absorb, the hows, the whys, and the risks," he says. Page five of the fund's 86-page prospectus includes this disclaimer: "The price relationship between the near month contract to expire and the next month contract to expire...will vary and may impact both the total return over time...as well as the degree to which its total return tracks other crude oil price indices' total returns."

Hyland's other main fund, U.S. Natural Gas (UNG), got so big last year that at its peak it owned the equivalent of 86 percent of the near-month natural gas contracts on the Nymex. As natural gas prices fell into the basement—traders call the notoriously volatile market "The Widowmaker"—UNG fell with them, and when gas prices rallied, UNG did not. The fund's growth raised concerns among regulators at the CFTC, which last year began debating position limits; it will revisit the issue this year. The fund grew so large it had to freeze its position and start buying over-the-counter derivatives—unregulated contracts tied to gas prices—instead of futures. Hyland told the CFTC last year that it was "gibberish" to say UNG had any effect on natural gas prices.

New Oversight?
The financial reform bill President Barack Obama signed on July 21 includes a few provisions that may help the CFTC address the commodity ETF mess. The new regulations enhance the CFTC's ability to prosecute trading abuses, and set position limits on over-the-counter swaps, like those UNG has been buying. How much the new law will help remains to be seen, says Jill E. Sommers, one of the agency's five commissioners, because Congress still needs to appropriate funds and write guidelines for implementation and enforcement. "We'll need additional dollars to carry this out," she says, adding that it's too early to say whether the CFTC has the authority needed to crack down on pre-rolling. "We're at the beginning of the rule-writing process, so it's premature to say whether additional authority is going to be needed," she says.

By requiring the commission to impose caps on energy trading within a year, the rules may limit the size of some funds. It does nothing to directly address the market impact of the funds, says CFTC commissioner Bart Chilton. He likens ETF investors' supersized role to the one Tom Hanks played in the 1988 film Big—a little boy in a man's body. "The dynamics of the market have changed so dramatically over the last several years with this new influx of capital that is massive in size and passive in strategy," Chilton says. "That has had an impact that wasn't anticipated."

The CFTC's explicit responsibility is to guard against commodity market distortions, not to look out for ETF investors like Gordon Wolf. "We are concerned about both," says Sommers. Adds Gensler: "The CFTC is aggressively using its authority to police the markets for fraud, manipulation, and other abuses. Investors also should fully research any products before they buy." As Hyland likes to point out, the risks are described in each fund's prospectus. Now investors are learning what those words actually mean.

Robison is a reporter for Bloomberg News. Loder is a reporter for Bloomberg News. Bjerga is a reporter for Bloomberg News.

States in Trouble (Daily Beast)

50 States in Debt

#1, Rhode Island
Debt 2009: $9.2 billion
Projected 2012 Budget Shortfall: $290 million
GDP 2009: $47.8 billion
Debt/GDP Ratio: 19.19%
Unfunded Pension Liabilities: $4.4 billion (39%)
Unfunded Health Care & Other Liabilities: $788 million (100%)

On the chopping block: Rhode Island’s judges and court workers are trudging along despite a lack of funds cutting paid work days per week and 53 positions that remain unfilled. “This is not a time for expensive initiatives and hefty new capital projects. It is a time to do the very best with the limited resources we have,” said Chief Justice Paul A. Suttell. The states court system has responded to budget shortfalls in part by disposing of cases on backlog.

#4, Illinois


Debt 2009: $57.0 billion
Projected 2012 Budget Shortfall: $15.0 billion
GDP 2009: $630.4 billion
Debt/GDP Ratio: 9.04%
Unfunded Pension Liabilities: $54.4 billion (46%)
Unfunded Health Care & Other Liabilities: $39.9 billion (100%)

On the chopping block: The state's mental-health services will lose $91 million in funding during the next fiscal year as a result of Illinois' extreme budget gap. Illinois Human Services chief Michelle Saddler has expressed her worry over the effect of the large cut, saying, "I'm concerned that we will see a real public-health crisis and real public-safety crisis with these cuts."




#6, New Jersey


Debt 2009: $56.9 billion
Projected 2012 Budget Shortfall: $10.5 billion
GDP 2009: $483 billion
Debt/GDP Ratio: 11.78%
Unfunded Pension Liabilities: $34.4 billion (27%)
Unfunded Health Care & Other Liabilities: $69 billion (100%)

On the chopping block: One of the biggest losers will likely be school districts, which are slated to have their funding decreased by $820 million. With $268 million coming in federal aid, 4,000 teachers may be able to keep their jobs. “Public opinion may well shift a bit when school is back in session, once parents start seeing the effects,” said Ben Dworkin of the Rebovich Institute for New Jersey Politics.

#23, New York


Debt 2009: $122.7 billion
Projected 2012 Budget Shortfall: $9.0 billion
GDP 2009: $1.1 trillion
Debt/GDP Ratio: 11.22%
Unfunded Pension Liabilities: $0
Unfunded Health Care & Other Liabilities: $56.3 billion (100%)

On the chopping block: With the threat of a shut down in Albany and the state’s finances verging on desperate, the state legislature finally passed a budget in early August. The state's public schools may also be nearing desperation, as the cuts proposed by Governor David Paterson include chopping $1.1 billion for state aid to schools.




#28, Nevada


Debt 2009: $4.4 billion
Projected 2012 Budget Shortfall: $1.5 billion
GDP 2009: $126.5 billion
Debt/GDP Ratio: 3.51%
Unfunded Pension Liabilities: $7.3 billion (24%)
Unfunded Health Care & Other Liabilities: $2.2 billion (100%)

On the chopping block: The Governor Guinn Millenium Scholarship program, which provides up to $10,000 toward college tuition for high school seniors, lost $12.6 million in funding last year as Nevada legislators closed the state's budget gap for the current fiscal cycle.





#40, Virginia


Debt 2009: $24.3 billion
Projected 2012 Budget Shortfall*: $2.3 billion
GDP 2009: $408.4 billion
Debt/GDP Ratio: 5.95%
Unfunded Pension Liabilities: $10.7 billion (16%)
Unfunded Health Care & Other Liabilities: $2.6 billion (66%)

On the chopping block: Health Care. New federal money will soften the blow of the loss of health coverage for low income Virginians, but the $293 million the state received is still $100 million less than lawmakers were banking on.

*Virginia operates with a 2-year budget.



#41, Florida

Debt 2009: $38.9 billion
Projected 2012 Budget Shortfall: $3.6 billion
GDP 2009: $737.0 billion
Debt/GDP Ratio: 5.28%
Unfunded Pension Liabilities: -$1.8 billion (-1%)
Unfunded Health Care & Other Liabilities: $3.1 billion (100%)

On the chopping block: The judicial system. Staff have been relieved, basic maintenance has been cut, programs for drug offenders have been reduced, and one Tampa courthouse is infested with vermin. All that hasn’t stopped the 1st District Court of Appeal in Tallahassee which is building a $48 million courthouse complete with 60-inch LCD flat screens for each judge.





#48, Texas


Debt 2009: $30.4 billion
Projected 2012 Budget Shortfall: $13.4 billion
GDP 2009: $1.1 trillion
Debt/GDP Ratio: 2.66%
Unfunded Pension Liabilities: $13.8 billion (9%)
Unfunded Health Care & Other Liabilities: $28.6 billion (98%)

On the chopping block: Texas has one of the better debt-to-gdp ratios at the moment, but its legislature is still having trouble coming up with the cash for the next two years of operating expenses. That could mean unpaid furloughs, salary freezes and four-day work weeks for state employees. "There's not any fat left," said Andy Homer of the Texas Public Employees Association. "This is cutting to the bone."



#50, Nebraska


Debt 2009: $2.5 billion
Projected 2012 Budget Shortfall: $314 million
GDP 2009: $86.4 billion
Debt/GDP Ratio: 2.91%
Unfunded Pension Liabilities: $755 million (8%)
Unfunded Health Care & Other Liabilities: n/a

On the chopping block: Students are going to have to pony up more money for tuition at all University of Nebraska campuses, according to a budget proposal released by president J.B. Milliken. With less money coming from the state, "I'm concerned about the investment in education," Milliken said.

Top 10 Investment Warnings for 2011 (Utah Division of Securities)

01/03/2011

Utah Division of Securities identifies Top Ten Investment Alerts for 2011

Francine A. Giani, Executive Director for the Utah Department of Commerce announced that the Division of Securities has released a top ten list of investment warnings for 2011. The list details fraudulent activity tracked by the Division of Securities over the past year and offers predictions on which investment schemes to watch for in 2011.

“Securities fraud continues to make headlines so we are asking citizens to add financial resolutions to their New Years list,” said Francine A. Giani, Executive Director of the Utah Department of Commerce.

“During fiscal year 2010, our office had over $5.3 million dollars in total fines for fraud cases which is more than twice what was assessed in 2009,“ said Keith Woodwell, Director of the Division of Securities, ”As consumers look to re-energize their retirement investments in the New Year, we urge investors to protect their nest egg by checking out a promoter’s background and any investment offer with our Division.”

Utah Division of Securities Top Ten Investment alert predictions for 2011

1. Affinity Fraud - Affinity fraud is when someone abuses membership or association with an identifiable group to convince a potential investor to trust the legitimacy of the investment. Common affinity groups include religion, ethnicity, profession, education, common handicaps, language, age and any other common likeness or shared characteristics that allow investors to trust members of the group. Rather than trusting a person or company due to a common affiliation with a given group, investors should obtain and review a disclosure document that explains the investment opportunity, the background of the management, the amount of money to be raised, the intended use of the money raised, and all the risks associated with making an investment. Upon receipt, investors should review all disclosures with an independent accountant, attorney, or investment professional to receive an unbiased opinion of the investment and the person offering the investment.

2. Inverse and Leveraged ETFs - Exchange-traded funds (ETFs) that offer leverage or that are designed to perform inversely to the index or benchmark they track—or both—are growing in number and popularity. While such products may be useful in some sophisticated, short-term trading strategies, they are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis. Most leveraged and inverse ETFs “reset” daily, meaning that they are designed to achieve their stated objectives on a daily basis. Due to the effect of compounding, their performance over longer periods of time can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time, particularly in volatile markets. Therefore, inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session.

3. FOREX Trading Programs - The most successful perpetrators of investment scams cloak their scam in a veil of legitimacy. FOREX is a term used to describe the legitimate foreign currency exchange market. The value of one nation’s currency, as compared to another nation’s currency, fluctuates on a continuous basis. These fluctuations can sometimes be quite dramatic and depend on innumerable complex factors. Due to the complexity of factors affecting the exchange rate of one currency to another, speculative FOREX trading bears a high level of risk. Despite the risk inherent in FOREX trading, there is always someone new who thinks they can simplify this complex market into a “fail-safe,” “low risk” or “no risk” system that “guarantees” the preservation of capital and significantly higher rates of return than can be achieved investing elsewhere. These FOREX trading programs are often designed to automatically engage in currency trades based on predetermined events or algorithms that the designer has “developed after years of personal experience and working with the top minds in the financial services industry.” The FOREX trading program designer may simply want an individual to purchase this trading system as an investment. Then it is up to the investor to generate the returns or, more likely, discover the flaws in the “fail-safe” system. The investor may also be enticed to invest directly with the individual who has developed this system, who will then trade on investors’ behalf. Unfortunately, under these common circumstances, the person who collected the money may or may not ever invest the funds before they regrettably inform investors some tragic unforeseen event has caused the loss of capital. In fact, in several cases investigated by the Division of Securities, promoters who have promised “guaranteed” returns in their “proprietary” FOREX trading programs have simply stolen the money and spent it on supporting their own lifestyles.

4. Structured Investment Products - Structured investment products are securities derived from or based on a single security, a basket of securities, an index, a commodity, a debt issuance and/or a foreign currency. As the definition suggests, there are many types of structured products from market-indexed CDs offering protection of the principal invested, to a multitude of other structured notes and investments that offer limited or no protection of the principal. The Division’s greatest concern with structured products is the investors’ ability to fully understand the investment. Structured product disclosures are generally complex, making it difficult for the average investor to comprehend them. Without an effective understanding of the investment the investor can have a difficult time knowing the risks, costs, liquidity, and tax-consequences associated with the investment.

5. Promissory Notes - Promissory notes are a written promise to pay a specified amount, to a specific entity at a specific time or upon demand, with or without interest. Promissory notes offered to retail investors carry significant risk. When investing, higher returns are accompanied by a proportionate amount of risk. A track record of paying high interest and even repaying principal is not an assurance that you will get your money back if the company fails. Early investors in a Ponzi scheme often receive interest payments and in some cases principal. Promissory notes are rarely suitable for retirement money, or money borrowed against equity in ones home.

6. Start-up Companies on the Verge of “Going Public” - The lure of getting in on the “ground floor” of a hot start-up business is a classic temptation for investors. Promoters know this, but they also know the deal will be much sweeter if they can promise not only great profits, but also a way for the investor to cash out those profits relatively quickly, if necessary. Unscrupulous persons will often claim that the shares being sold to investors are on the verge of “going public” and will be freely traded on a major exchange. Frequently, promises are made that the shares will trade at a specific future price of $5.00 to $10.00 or more per share. In most of these cases, the reality is that no such public offering is being seriously pursued. “Going public,” in the sense promised by these promoters, is actually a highly expensive and time-consuming process that requires considerable assistance from legal, accounting, and investment banking firms. Only larger, more well-established businesses are usually in a position to register their shares for trading on a major exchange and to pay the ongoing regulatory costs of public registration. If approached by promoters making such promises, investors should contact the Division of Securities and the Securities and Exchange Commission to verify that the required registration statements have been filed.

7. Investment Pools Purchasing Non-Performing Loans - By the time the housing bubble burst, the mortgage and banking industries had made many loans they shouldn't have. As the housing and commercial real estate markets folded, those loans (and pools of those loans) stopped producing revenue, freezing lines of credit in the economy and contributing to the Great Recession. Many financial institutions have since collapsed under the weight of these non-performing loans, leaving the institution's assets to be auctioned off to willing buyers. The Division of Securities has seen a rising number of Utahns seeking to earn big returns by purchasing these non-performing loans. However, as with all investments, investors should remember the risk-reward principal: the greater the potential return, the greater the risk. Despite the ads on late-night television and the Internet, or the stories told during seminars and sales pitches, turning a profit on non-performing loans is a complicated and difficult undertaking. Enterprising individuals have created funds to pool investor money and purchase these non-performing loans. These pooled investment funds present additional risk to the investor and should be fully disclosed in a disclosure document (e.g., private placement memorandum). Investors should read the disclosure document carefully before investing in any pooled investment fund and only invest funds which they can afford to lose. Lastly, investors should always verify whether their investment professional (or the fund manager) is properly licensed and whether the fund itself is properly registered by contacting the Division of Securities.

8. Automatic Trading Software Packages - Some investors have resorted to using a computer to make investing decisions for them. Companies are selling computer software programs that analyze the market and make trades for the investors. Typically, an investor purchases the program, sets up a brokerage account, and places money into the account. The computer program will “track” and “analyze” the market and decide which trades to make. The account is linked up to a brokerage firm which will then make the actual trades based on the computer’s recommendation, using the funds from the investor’s account. Often, a promoter will not just sell the computer package, but will have “openings” for investors to participate in the program. Investors are charged a start up fee and commission fees in addition to the investment funds. Investors should be cautious when evaluating offers of such automatic-trading software packages. The Division encourages investors to do their own due diligence on those selling the programs or promoting them and ensure that you are dealing with licensed professionals. The Division of Securities also cautions any purchasers of such packages against the common practice of allowing family members or friends to “piggy back” on the purchaser’s account by co-mingling funds. The purchaser of the package may expose himself to liability for acting as an unlicensed investment adviser.

9. Iraqi Dinars - Since the beginning of the Iraq War in 2003, speculators have sought to profit by purchasing Iraqi Dinars. Unfortunately, the likelihood of investors seeing any return on their dinars is slim to none. This scam comes in three parts: the hyped returns that play on an investor's greed, the deceptive practices of Iraqi Dinar dealers, and the fundamental misunderstanding of international finance. Currently valued around 1,200 dinars to 1 U.S. Dollar, any appreciation in the value of the Iraqi Dinar would theoretically generate profit, but many websites selling Iraqi Dinars boast these returns could reach up to 1000 percent. Investors need to understand these figures for what they are: speculation and hype. Websites selling dinars also exaggerate or misrepresent history as proof that such profits are possible, but history teaches a vastly different lesson. First, the rapid appreciation of any currency's value is extremely rare (the opposite is much more likely), meaning investors should consider this a long-term gamble not a short-term guarantee. Second, investors may confuse the appreciation of a currency's value with demonitization, which is the process of governments replacing their old currency with a new currency. While Iraq is not likely to do so again (Iraq demonitized from October 2003 to January 2004), exchanging old currency for new currency still keeps the value in U.S. Dollars roughly the same. So new currencies do not generally indicate a new value. While hard currency scams are not new, the methods have evolved. Currency dealers previously avoided regulation by relying on the currency's numismatic value (treating the currency as a collector's item), now these dealers often register with the U.S. Treasury as a Money Service Business (MSB). An MSB registration is nothing more than a check-cashier or a money transmitter; it does not reflect any experience in trading currency nor entail any qualifications on the part of the dealer. The reason dealers seek this meaningless registration is to lend legitimacy to their scam and avoid proper regulation, which would entail oversight and require full disclosure be made to investors. Additionally, since no exchange exists for the Iraqi Dinar, dealers can charge whatever they want to sell and buy back the dinars. Investors should fully understand that a small increase in value will not likely be enough to breakeven after these fees are considered. Worst of all, some websites have even been selling counterfeit dinars. Ultimately, however, the power of hard currency scams come down to a subject most are unfamiliar with: international finance. The market determines currency values based on numerous factors. In the case of Iraq, many of these factors are political and unpredictable, making dinars a risky bet at best. Of all the risks though, inflation is the greatest. As an economy improves, workers find jobs and earn more money, increasing demand and, therefore, prices. As prices rise, the value of the currency falls. Another inflationary pressure may be the Iraqi government itself. As the Iraqi government seeks to improve conditions, it may be tempted to monetize their debt (essentially, print more money) and drive inflation further. Combating inflation is difficult for established governments and economies, let alone one emerging from a dictatorship, a war, and an ongoing insurgency, so even the best scenario of an improved Iraqi economy may not lead to profits for investors in Iraqi Dinars.

10. Unsuitable Variable Annuity Sales Practices - Aggressive marketing of variable annuity insurance products are a concern, especially when seniors are targeted. Sales pitches, which are frequently offered in conjunction with free lunch seminars, are sometimes used in an attempt to scare or confuse investors by claims that these products will protect or insure them against any market losses. While variable annuities can be appropriate as an investment in some circumstances, investors should be aware of restrictive features including potential surrender charges, tax penalties for early withdrawals, and limitations on the insurance guarantees. Brokers and investment advisers recommending variable annuities must collect information about your financial status to assess if a variable annuity is suitable for your individual circumstances. Protect yourself by asking the sales person to explain guarantees, liquidity issues, fees and market risks.

Three questions every investor should ask:


1.Is the person offering the investment licensed? Find out by calling the Division of Securities at (801) 530-6600.
2.Is the stock offering registered? All securities sold in the state must be registered or exempt. Before you invest your money, call the Division of Securities to make sure it is a legitimate offering.
3.Did the promoter give you a written prospectus summarizing the investment? Did he or she give you a copy of the financial statements showing how the company is doing? Has the promoter disclosed his or her prior business success or any previous criminal convictions or bankruptcies?

The Seven most common warning signs of investment fraud are:


1.Promises of high returns. Any claim that you can double your money in six months is a fraud.
2.Claims that the investment is guaranteed or that it has little or no risk.
3.Pressure to invest immediately because there is a deadline or only a few openings left.
4.Encouraging you to borrow money from equity in your home to maximize the profit you can make. Because all investments involve risk, no legitimate securities broker will recommend using home equity to make an investment.
5.Vague descriptions about how your money will be used or what the company does.
6.Claims that other people have already checked out the investment and are investing. These may include well-known members of the community or people within your affinity group (your church, workplace, or service organization).
7.The assertion that this investment involves new technology that can solve a problem that big companies in this industry have been unable to solve (such as drilling for oil in new places, new pharmaceuticals that cure well-known diseases, or high-tech inventions).

Investors should do business with licensed securities brokers and advisers and report any suspicion of investment fraud to the Utah Division of Securities by calling (801) 530.6600; toll free at 1.800.721.7233 or logging on to www.securities.utah.gov.

The New Estate Tax (Forbes)

Money & Investing
Rewrite Your Will
Janet Novack and Ashlea Ebeling 01.17.11, 6:00 PM ET


Over the pained howls of liberals, Congress has increased the exemption from the federal estate tax to $5 million, leaving fewer than 4,000 families likely to be stuck paying the 35% tax in 2011. While the new estate deal expires at the end of 2012, the $5 million figure is unlikely to fall. "Rates can fluctuate, but estate tax exemptions don't get reduced," says Columbia Law School professor Michael J. Graetz, who coauthored a book on the political battle over taxing inherited wealth.

That hefty $5 million exemption, combined with a new portability provision, should allow many affluent couples to simplify their planning, leaving their assets outright to each other instead of to cumbersome bypass trusts. Portability? If a married person dies in 2011 or 2012 without using up his full $5 million exemption (amounts left to charity or a U.S. citizen spouse are estate tax free and don't count against that exemption), the unused exemption is passed to the surviving spouse. That allows a widow or widower to leave as much as $10 million free of estate tax. (No, before you entertain lurid ideas, you can't stockpile multiple spousal exemptions through serial marriages. Only what is left of your last late spouse's exemption counts.) Here's a look at what you need to know and do in 2011.

Don't ignore the basics

Whatever your age, marital status or net worth, you need a will (saying who gets your stuff); a living will (stating your wishes about end-of-life care); a health care proxy (naming someone to make medical decisions for you if you can't); and a durable power of attorney (designating someone to act on your behalf in financial and legal matters if you can't). If your situation is very simple and you are cheap, using do-it-yourself software is better than nothing. (More than half of Americans lack wills.) If you have minor or disabled children, or substantial assets, or live in a state with its own version of an estate tax, spring for a lawyer.

Review any old estate plans

"People are going to have to undo a lot of the planning that's been done,'' warns Bernard Kent, a lawyer, CPA and managing director of Telemus Capital Partners in Southfield, Mich. Example: Many couples have old wills designed mainly to preserve the estate tax exemption of the first spouse to die, something the law now does. Under these old "formula" wills, when the first spouse dies assets equal to his or her federal estate exemption go into a "bypass trust" for their kids. The surviving spouse has access to the trust's earnings and, if need be, principal, but what's in the trust "bypasses" the survivor's estate. Problem is, with the exemption jumping to $5 million (it was only $2 million in 2008) the survivor could be left with nothing outside the trust. Moreover, individual retirement accounts, primary residences and other assets that shouldn't be in the trust for income tax reasons could be automatically sucked in, warns Portland, Ore. estate lawyer Marsha Murray-Lusby.

But don't be too quick to write off all trusts, she adds. Couples in a second marriage will want a fixed amount in a bypass trust to make sure kids from their first marriages aren't stiffed. A bypass trust can also provide valuable asset protection--a consideration if, for example, the surviving spouse is an architect, obstetrician or some other professional who could face big legal claims.

Still, many couples in stable first marriages might sensibly opt to leave everything to each other outright (with an "I love you" will) and include a backup "disclaimer" trust for the kids. With this setup, at the death of a spouse the surviving widow or widower can decide, based on the laws and the couple's assets at that time, which assets, if any, to disclaim (turn down) and divert into the kids' trust.


--
Plan for state taxes

Currently 21 states and the District of Columbia have estate or inheritance taxes, or both, in place for 2011. Estate taxes are levied on any amount above an exemption--typically $1 million--left to someone other than a spouse. Inheritance taxes are based on who gets the cash and can hit the first dollar of a bequest. So, for example, Maryland imposes an estate tax of up to 16% above a $1 million exemption and a 10% inheritance tax on every dollar left to a niece, nephew, friend or lover, but not on money left to children, grandchildren, parents or siblings. (Any estate tax owed is reduced by the inheritance tax paid.)

Bottom line: Couples worth $2 million or more living in Maine, Maryland, Massachusetts, Minnesota, New York and Oregon, which all have $1 million state estate tax exemptions, will still want to put at least $1 million in a bypass or disclaimer trust at the first spouse's death.

For details on your own state's estate tax exemption for 2011, see
the Forbes Tax Map.


Give while you're still breathing

As in past years you can make annual gifts of up to $13,000 to as many people as you want without worrying about gift taxes. If you want to give even more, there's a lifetime gift tax exemption that jumps to $5 million in 2011 and 2012, up from $1 million in 2010. (The estate tax lapsed in 2010, but the gift tax didn't. Any gift tax exemption used reduces an individual's estate tax exemption.) The generation-skipping transfer tax, an extra tax on gifts and bequests to grandkids if their parents are still alive, also now has a $5 million exemption, up from $1 million in 2009.

When that $5 million gift/GST exemption is leveraged with such fancy wealth-transfer techniques as grantor-retained annuity trusts and installment sales to trusts, the rich will be able to transfer huge sums, tax free, to trusts for their kids, grandkids and generations beyond. (Dynasty trusts, they're called.) "This is a huge gimme to the wealthy,'' says Jonathan Forster, an estate lawyer with Greenberg Traurig, in McLean, Va. Since GRATs and other techniques could be restricted when Congress finally goes into deficit-cutting mode and since the GST tax exemption isn't portable between spouses, lawyers are advising the very rich to begin transferring assets in 2011.

Less wealthy folks can make good use of the gift exemption, too--to avoid state taxes. Oddly most states with inheritance and/or estate taxes don't tax gifts. (The big exception is Tennessee, which imposes up to a 16% tax on gifts above $13,000 a year to close relatives and above $3,000 to others.) So if you have enough left for your own retirement years, you can start reducing prospective state tax bills by making gifts. This is also a boon for unmarried couples who want to transfer assets between partners. Be careful, however, of quirky state gotchas; for example, in Maryland, gifts made within two years before the donor's death get hit with state inheritance but not state estate tax, says Rockville, Md. lawyer Steven Widdes.

Keep income taxes in mind

Under the 2011 and 2012 estate tax law (and likely in the future, too) at your death, all your assets are "stepped up" to their current market value--meaning heirs can sell right away without owing capital gains tax. So don't give away already appreciated assets (say a primary or vacation home or collectibles) you might otherwise hold until death.

On the other hand, the $5 million gift tax exemption provides an opportunity to shift income to relatives taxed at lower rates. Got $30,000 worth of Google stock you bought for $10,000 and are ready to dump? Give it to your starving-artist daughter and she can sell it at a 0% capital gains tax rate in 2011 or 2012. (Warning: Full-time students up to age 24 are subject to the kiddie tax, which taxes investment income and gains at a parent's higher rate.)

CPA Robert Keebler of Green Bay, Wis. suggests the owner of a profitable small business run as a pass-through (the business doesn't pay corporate income taxes but passes all profit through to its owners' tax returns) consider gifting partial ownership stakes to adult children, who might pay taxes on their share of profits at, say, a 25% rate, instead of the 35% the parents pay. "The income-shifting opportunities are enormous," he says.