For the past couple of days, I’ve written about some of the Wall Street shenanigans such as the greed that drove MF Global into bankruptcy and rogue traders who lose billions for their firms. These are just a couple of the tricks in Wall Street’s bag that result in costly scandals that rock investment markets and wreak havoc on investors like you and me.
But there are ways that investors can protect themselves. The excesses of MF Global and rogue traders come from proprietary trading that puts the firm’s interests before its customers. This is the crux of the problem with MF Global. But not only did it risk its own company funds, but it seems to have “misplaced” $1.2 billion in client funds — suspected to have been traded on the company’s behalf.
This is precisely how rogue traders get their power. They’re authorized to trade, mostly, for their companies. And they often have the ability to trade millions of dollars worth of investments in one transaction — with little oversight. As my story noted, when they come down on the wrong side of the transaction, billions of dollars can be lost, leading to company failures and massive investor losses.
Another tactic that puts the screws to a firm’s own investors is when its proprietary trading desks trade opposite of what the company’s agents are recommending to its clients. Goldman Sachs (NYSE:GS) was charged by the Securities & Exchange Commission for selling subprime mortgages to its clients at the same time it was essentially shorting them. And just two weeks ago, it was reported that while Goldman upgraded European investments, its trading desk was selling them!
I’m not picking on Goldman; these kinds of transactions occur daily on proprietary trading desks around the world.
The 2008 financial collapse has created calls for more regulatory oversight, but don’t get your hopes up. The new Volcker Rule, proposed in the 2010 Dodd-Frank Act and due to take effect next July, supposedly bans proprietary trading at institutions that also take customer deposits. But it’s been watered down, has numerous exceptions and the investment community continues to blast it. Consequently, don’t expect it to have any major impact. As I said yesterday: a lot of lip service and no results.
For a couple of decades I’ve made my living recommending the shares of small and midsize companies, those that are experts in a handful of products, services or technologies, and whose financial statements are visible. I’ve purposely avoided huge conglomerates, like the Enrons of the world, whose legions of subsidiaries makes a true picture of their finances almost impossible to read.
I think most investors would do well, likewise, by avoiding the big banks and brokerage firms that have too many sources and uses for their money. Most of us aren’t rich enough to deal with hedge funds like MF Global, but during the recent scandal, even respected firms like Merrill Lynch and Bank of America (NYSE:BAC) illustrated that they couldn’t be trusted with investors’ money, riding the coattails of the subprime debacle right to the end.
Plenty of smaller firms don’t have thousands of traders working on their behalf or creating esoteric complex instruments to maximize income. Choose one that profits from transacting business for its customers, not itself.
Wall Street has plenty of other ways for separating investors from their money, including:
Biased analyst reports. I’m not sure how many investors still believe that analyst reports are objective, but you should know that most are not. Brokerage firms make a hearty percentage of their income from underwriting fees — bringing stocks to market in initial or secondary offerings, as well as from fixed-income underwritings. One of the ways they sell those issues to the public is by releasing very complimentary reports on the shares.
Since the 1929 stock market crash, the SEC has issued numerous rulings, establishing and trying to strengthen the “Chinese Wall,” separating investment banking from research. But in reality, the bricks in that wall have been crumbling. Even when I was a brokerage analyst 20 years ago, that wall was continuously breached, with investment banking mavens constantly requesting the research analysts to write a “nice” report for their newest clients.
Investors should read the fine print to determine if that “glowing” research recommendations was written about one of the brokerage firm’s investment banking clients. I’m not saying they’re all fluff jobs, but it pays to be aware of the tendency, and to always seek a second, more unbiased opinion before investing your hard-earned money.
Often, one of those unbiased opinions can be found at a brokerage firm that doesn’t have anything to win — or lose — from its analysis. In many cases, that firm will be a “boutique” brokerage firm, a small, local company that keeps track of public companies in its geographic region and that does little investment banking.
Incompetent ratings agencies. The three major credit rating agencies — Moody’s, Fitch and S&P — are still cleaning the mud from their faces from their blatant neglect in recognizing the subprime mortgage crisis that brought world financial markets to their knees in 2008.
But that’s not the first time they’ve proven their unreliability. You may recall they rated Enron’s bonds “investment grade” right up to when the company’s accounting fraud came to light in 2001. That ultimately caused its bankruptcy, sent executives to prison and costing shareholders more than $11 billion. The raters didn’t see the fraud coming at India’s Satyam, either, in which that company told investors it had $1.04 billion assets that never existed.
There are plenty of other examples, too, including the insurance and bank failures of the early 1990s that were largely unpredicted by the major ratings agencies. Only Weiss Ratings, a much smaller company in Florida, actually had the nerve to downgrade many of those companies early on.
The biggest problem is that the major ratings companies are paid by the very people they rate. If that doesn’t sound like a conflict of interest, what does?
It’s best to do your own homework, ask the right questions and try to find a second, unbiased opinion from a credible analyst. Again, perhaps from that boutique brokerage firm that knows its market.
Hidden fees for recommending certain investments. Investment firms are pros at hiding fees, often cloaking them in legalese that even the most astute investor can’t decipher. The only way you’re going to find out if your broker or fund manager has a vested interest in recommending a particular investment is in those disclosures. You can ask them, but be aware that they may not be truthful. Again, read the fine print. If someone is getting paid (just like the ratings agencies and the investment brokers) to give a sterling recommendation, you should automatically be skeptical that it’s unbiased.
Hypesters and “expert endorsements.” Most investors know that if they hang out in chat rooms, they need to be suspicious of folks who tout stocks — especially penny and resource stocks — as the hypesters are often just trying to drive the prices up so they can cash in and leave you with a stock on a rapid descent.
But what you may not realize is that those thick envelopes you receive in the mail, or the fabulously written missives in your email box — that promise untold riches in certain companies are often cut from the same cloth. Many times, you’ll see a well-known financial adviser promoting the stock. Be careful. They’re not all legitimate.
I’m constantly approached by folks asking to pay me to use my name to “recommend” a company in what is nothing more than a public relations effort. I don’t do that, and neither do legitimate advisers. When you see my name recommending a company, it’s because I have done the analysis on it myself. So please, buyer beware. Don’t believe everything you read; do a little research on your own.
The bottom line is this: Your broker is probably not your friend. He’s someone trying to make a living, and he’s generally not looking out for you. It’s obvious that the investment industry is a failure at “self-regulation.” And the government is too tightly aligned with the industry and doesn’t have the will or the muscle to actually make the needed regulatory changes that might serve the public.
But you can take steps to protect yourself. Question everything you hear. Take nothing at face value. And do your own homework. One of the best adages that will keep you from harm is this: “If it sounds too good to be true, it is.”