Slouching Towards Wall Street… Notes for the Week Ending Friday, February 4, 2011
Another damned thick square book. Always scribble, scribble, scribble, eh?
It was the best of Crisis Commissions, it was the worst of Crisis Commissions.
While we were on vacation — we missed you, did you miss us? — the Financial Crisis Commission published its lovingly crafted Report, leading Congressman Darrell Issa to squawk about the Commission’s wasting taxpayer funds through “financial mismanagement and partisanship.” This is the same decidedly non-partisan Issa who called President Obama “one of the most corrupt presidents in modern times” (San Francisco Chronicle, 28 January, “Financial Crisis Report Out — Hint of Violators.”)
We take our quote from the Duke of Gloucester, patron of Edward Gibbon, who greeted the second volume of Decline and Fall of the Roman Empire with those words. What strikes us immediately — and repeatedly — about the Commission’s big fat book is that they had a lot of fun writing it. And while you are much more likely to read a book if it is written in engaging prose, we doubt any substantive policy changes will emerge from this opus. For once, we find ourselves in agreement with Congressman Issa: what the heck were these people doing with our money? The lasting contribution of the Report may be to, once and for all, confirm the dubious reputation of the vanity publishing industry.
The Chronicle reports the Commission is mandated to refer “any person that the commission found may have violated laws” to the Justice Department and to state authorities and quotes well-placed officials confirming “the feds have been so informed.” Yet for all the jawboning, there are hints that only civil charges will be brought. This is consistent with a newly-muscled SEC that has taken a world class black belt prosecutor and turned him into a high-powered bill collector, upping the ante in settlements, then sending the same players back into the game.
But that may be changing. Manhattan DA Cyrus Vance, Jr. wants mandatory prison time for people convicted of major securities fraud and is calling for the New York State legislature to impose prison terms of up to 25 years for financial fraud. We wonder who will finance the next political campaign of anyone who votes in favor.
One financial market player who may end up wearing state-issued pajamas is money manager Vincent McCrudden (Bloomberg BusinessWeek, 26 January, “Money Manager Indicted for Threatening US Regulators.”) McCrudden allegedly “threatened in e-mails to kill 47 current and former officials of regulatory agencies, including CFTC Chairman Gary Gensler and SEC Chairman Mary Schapiro.” The indictment quotes e-mails saying “you are going to die a painful death” and says McCrudden wrote on his website “Go buy a gun, and let’s get to work taking back our country from these criminals.” Talk about Best Executions…! Presumably even a Congressional Commission could nail this guy.
And speaking of Congressional competence, we returned from abroad to find that the Department of Treasury has grown a sense of humor. Mary Miller, Secretary Geithner’s assistant for financial markets, asked for comment on the debate around raising the nation’s $14.3 trillion debt ceiling, offered Treasury’s official comment: “We expect that Congress will do the right thing.”
It’s great to be back in America.
Who says the SEC can’t get anything done?
Despite muscular efforts by the new Republican Congress to withhold funding and force a shutdown of the Commission, the agency has managed to grind out rule proposals as required under Dodd Frankenstein and get them into the public arena for comment and evisceration. One thing you have to give the SEC: they know how to push paper.
Last month, despite not having been given more money by Congress, the Commission managed to publish a 208-page study recommending that brokers and advisers be held uniformly to a fiduciary standard, which would require them to put their clients’ interests before their own in all their dealings.
It might surprise you to learn that, not only is this not currently true, but even for people for whom it is true, it’s not always true.
Consider the nice young man who manages your investment portfolio. We’ll call him Ben. Ben manages your money in a private account under an advisory contract. This gives Ben free hand to buy and sell securities at his own discretion. You get a monthly statement that shows what the account has done, and how much it has gained or lost. You see how much Ben takes in management fees — but not necessarily how much Ben has earned on the transactions in the account. You see, Ben is also a registered stockbroker and his brokerage firm is affiliated to his advisory firm. You may not have realized that it is possible for your money manager to also be your broker.
If you are like most folks, you give your money to someone to manage because you trust them. And if you trust them to manage your money, you are going to trust them with every aspect of the process. Ben uses his own broker dealer to execute the trades in your portfolio, which he explained to you when you set up your managed account. And the disclosures are in the documents you executed when you signed up to have him manage your money. It made sense to you. Wouldn’t you want Ben to execute your trades on his own trading desk, where he has control?
And as disclosed, Ben is making a little extra on your account because he runs the order flow through his own trading desk. And Ben can raise or lower the commissions he charges. Call it a hedge.
If Ben were running your portfolio’s trades through a separate brokerage firm, he would be hounding them for commission discounts under the rubric of Best Execution. But also since, as a money manager, he gets paid based only on assets under management — or on the performance of the account. Every penny counts; thus, the compensation structure reinforces the fiduciary requirement: both Ben and you want the lowest commissions possible, so there will be more money in the account. Ben’s interests and yours are aligned.
But since Ben uses his own trading desk, he would be a fool to give too great a discount. What happens if Ben loses you money? What if you pull your account? No management fees, no performance fees. At least Ben has the commissions from your trades. In short: Ben’s managing your money as an adviser is a Fiduciary relationship; his acting as broker to the account that he also manages is not. Did you notice how all of a sudden your interests and Ben’s diverged? Conflict lies at the heart of this relationship, which is precisely the kind of situation the new fiduciary standard was intended to address. Don’t worry, Ben. It won’t.
Critics of the proposed fiduciary standard claim it will be too expensive and cumbersome to implement, thus raising the cost of doing commission-based business. Some argue these increased costs will disadvantage lower-income clients, who will find it prohibitively expensive to transact business through their brokers. We note that low-income investors do not have a monopoly on stupidity — indeed, in the financial marketplace laws and regulations only get changed when very rich people’s stupidity is revealed. But lower-income investors have less resilience and suffer greater devastation, even when losing a small percentage of their net worth. Put simply, low-income people are not rich.
There are the routine nonsensical comments, made largely by people who have been asked for quotable sound bites and never heard the Talmudic dictum that it is better to remain silent and be suspected a fool, than to speak and remove all doubt. “The devil is in the details;” “This raises controversial issues;” “The SEC can make this workable or not.” And a number of observers have criticized the report for being long on words, but short on specific directives for implementation and application of the standard. Obviously the SEC isn’t about to impose a rule that Wall Street might complain about. The outcome of this process will likely be a restrictively defined set of activities and individuals who are to be treated under a strict fiduciary standard, plus a broad menu of exemptions.
We predict there will be an exempt class of customer, and probably an opt-out option for individuals above a certain income level. This should prove a devilish detail indeed. Brokers will call their customers and explain that, under the new rule, there will be restrictions with respect to the type of transaction or product they can recommend. The best thing that ever happened to high producing brokers will be when the SEC creates a list of prohibited products and trade styles for fiduciary accounts. Ben will call you and say “I know you like to trade actively in your personal account, and that sometimes you like to take speculative positions. Under the new fiduciary standard, we won’t be allowed to put more than five percent of the portfolio into speculative securities.” You are already starting to get uncomfortable.
“And, you know,” Ben continues, “those speculative securities you like to trade once in a while — the less liquid they are, the higher the transaction costs. Under the new rules, we won’t be able to trade them at all, if the commissions are deemed too high. Like, you know that Bulletin Board stock your golf buddy told you about, where you made ten times your money…?” By this point in the conversation, you’re ready to rip up your Sierra Club membership card and write a check to the National Rifle Association. Before you can say “Alan Greenspan,” you send in the send him the opt-out form, and Ben keeps on ringing the cash register.
Said one industry executive, “our worst case scenario would have been an overly restrictive call by the SEC that would not have permitted, or choked off, choice and access for investors. We saw no sign of that.” What a relief…
Even for lower income investors, this new standard will probably offer only marginal protection. By making lawsuits and adverse judgments more likely, the fiduciary standard will make it more difficult for bad actors to churn accounts and consistently charge excess commissions. Brokerage firms will lay very tight restrictions on the products and types of dealings permitted with customers who come under the standard. More likely, many firms will assign all fiduciary customers to a special unit, and free up their more significant producers to deal with exempt customers. This means the lower-income customers will be deprived of access to more experienced professionals.
To those folks who complain that imposing a fiduciary standard will incur more compliance coverage, more disclosure requirements, and thus raise the cost of doing business: get with the program! The cost of doing business is going up because of everything that’s happened in the last three years. Because hiring big new compliance departments will be the most visible — and least effective — way for Wall Street to show they have taken to heart the pain of the average investor. If history is a guide, the legal and compliance bubble should burst before 2014. We will design the forms for disclosure and consent for fiduciary customers, we will do the customer reviews, will draft the compliance procedures and do the surveillance and record keeping. In less than two years, half the compliance professionals hired since the beginning of 2010 will be out of work again and the New York Mets will be playing their home games at Madoff Field. As our old boss used to say every time we tried to implement new oversight procedures: We’re in the brokerage business, my friend, not the compliance business. Not to worry, Ben.
Vamos a estar mucho tiempo enterrados. (“We will be buried for a long time.”)
The baby boomers represent a great marketing opportunity — and hence a tremendous investment opportunity. One could have become very rich — and very predictably so — by investing successively in companies in the business of layettes, then diapers, then toddler shoes, school supplies, summer camp equipment, college anything… on to health clubs, plastic surgery, medical clinics and finally, hospice. It was predictable that, with the boomers in their 60’s, the business of death would emerge as a major investment theme.
Wall Street’s death benefit securitization program received serious media coverage in 2009 (Slouching Towards Wall Street, 11 September 2009, “Death Swaps: The Last Investment You’ll Ever Make.”) It was not well received. Still, we predict death will end up as a hot investment. They just have to work out the kinks. In fact, the Wall Street Journal (2 February, “Fallout From Life Policies: Insured Suits”) reports investors bought $12 billion in life third-party insurance policies in 2008 — the year the Journal characterizes as “heady” for this niche investment.
The article tells of one Bruce Porter, an 81 year old rushed to the hospital when he thought he was having a heart attack. As he lay recuperating (it was not a heart attack) he was visited by his insurance agent who said his failing health was good news, as it now made his $6 million life insurance policy very marketable. Mr. Porter had purchased the policy with the express purpose of selling it to an investor — not a particular investor, just one of the purported army of savvy folks with open checkbooks looking to cash in on the ultimate Sure Thing.
Alas, Mr. Porter’s health improved. Rather than find a buyer for his policy, Porter ended up having to pay overdue premiums of $25,000 a month and is on the hook for a personally guaranteed $650,000 bank loan that secures the policy. He is now suing the insurance agent, alleging that he was misled about the policy and its marketability.
We’re not sure who is the greater ass in this sorry tale. First, there is the society that so pathetically undervalues the lives of its members that it seeks to turn their demise into a trade. As to insurance regulation — which is handled state by state — if a person can not buy life insurance on another without a legitimate Insurable Interest, is buying insurance on oneself with the intent to flip it not inherently fraudulent? It seems that Mr. Porter is, himself, principally to blame for rushing to cash in on his own death, and the story says a wave of older folks, all in better than expected health, are suing the insurance companies, agents and banks involved in their failed investment in life insurance policies. Here’s the Catch-22 of life insurance: if you are alive, you will not have it to spend; if you have it to spend, you aren’t alive. This is a dilemma that only an investment banker can solve.
This market originated in the tragic needs of the terminally ill whose resources have run out. Often the only way they can spend their last days in some modicum of dignity — and not run through their family’s savings — is to sell their life insurance policy in what is called a viatical settlement. It is quite a leap from helping a family care for a dying loved one, to the 2008 figure of $12 billion in policies bought by investors. The intentional purchasing of overpriced policies may be good for the industry. The premium on a term policy for an 80 year old is far above that for a 30 year old, and the attendant commissions to the agent much higher — watch for a sudden upsurge in Million Dollar Roundtable members — but we wonder whether it distorts the insured base in ways that disadvantage other policy holders. Whatever the benefits to the insurance industry, it creates a distortion in the marketplace that may be held up as a paradigm for the way improper speculation skews market dynamics. Finally, we are baffled that this is not banned in all fifty states.
One can make a case for speculators taking the other side of legitimate hedgers’ transactions — contracts on such commodities as sugar, cotton and soybeans would not be viable in many cases if not for the lubricant of speculative money. The first question that market economists and regulators must ask is, what is the natural level of prices and liquidity, and how much is this distorted by speculation? The life insurance industry may provide a clear cut laboratory for viewing the effects of improper speculation — that is, speculation where there is no legitimate other side of the trade.
Bruce Porter, featured in the Journal article, had no legitimate interest in insuring his own life. His only purpose was to flip his policy to an investor. This is like people who bought multiple condos during the housing bubble. As with the foreclosed units now clogging the market, these toxic life insurance policies are the equivalent of properties whose owners never intended to live in them: their entire economic value rests on froth. Mr. Porter et al should swallow very, very hard and admit they were blinded by greed.
Elsewhere, University of California law professor Osagie Obasogie writes (New Scientist magazine, 22 January, “Clinical Trials On Trial”) that “vulnerable people are increasingly targeted as subjects for clinical research.” The horrors inflicted by our government on its own citizens in the name of science is not limited to the Tuskegee syphilis study. “At almost the same time as Nazi doctors were on trial at Nuremberg,” he writes, the US Public Health Service paid syphilitic prostitutes to have sex with Guatemalan prisoners and military personnel to test the efficacy of penicillin. It is not clear to us why researchers chose to infect, then treat unwitting male subjects, rather than simply treat the infected women. The revelation of this episode, in a paper by Susan Reverby of Wellesley College, prompted President Obama to instruct his Bioethics Commission to “protect people from harm or unethical treatment” in medical testing.
According to Bloomberg Markets, almost 37,000 clinical trials were performed in 2001-2004, six times as many as in 1981-1984. Government funding for basic scientific research continues to plummet — according to one source, less than 10% of approved grants are being funded — and the drug industry, under threat of having intellectual property protections eviscerated, “is resorting to extreme measures” to ramp up research while keeping costs down.
Clinical trial participants are paid, sometimes thousands of dollars, which attracts the poor and undocumented aliens. Professor Obasagie writes that “over 50% of all clinical trial sites are outside of the US, with India and sub-Saharan Africa becoming increasingly important.” Beyond the reach of the FDA, drug companies may run riskier human trials, as witness Pfizer’s recently settling charges by the Nigerian government that the company “illegally tested an experimental antibiotic on children, leading to 11 deaths.”
Finally, government advisory groups are pushing to loosen restrictions against allowing pharmaceutical testing on prisoners. With recent cost cutting measures affecting the jail population — New York has cut back on prisoners’ food rations from eight slices of bread daily to six — prisoners may be more motivated to trade what they can, when they can. President Obama’s Bioethics Commission is to “review the rules” under which trials are performed, a process that will likely be muddied by the magnitude of campaign contributions from the health care and pharmaceutical industries, who are right up there with the insurance and securities lobbies. Indeed, the only sure thing in this whole sorry picture is that in America’s high-low society, the weak have no voice.
All they can do, in fact, is sell themselves. If not while alive, then after death. Curiously, selling death benefits produces the only securities investment that comes with a guaranty: the seller will die. But many who took out expensive policies on their own life are discovering that, even in a trade with a guaranteed outcome, price matters.
Look for a new investment product to hit the market, where prisoners serving long sentences sign up for high-risk drug trials. The payments they receive as participants will go to pay the premiums on high death benefit insurance policies, which will be packaged into securities that will end up in your pension account. Proving that in addition to Death and Taxes, Investment Banking is also inevitable.
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