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Wednesday, April 23, 2008

Senator Grassley and the SEC

It’s well known to anyone with experience representing individual investors that the SEC is shamefully ineffective when it comes to regulating the major brokerage firms. To wit: the SEC might have prevented the collapse of the auction rate securities market. The agency knew of extensive wrongdoing in the marketplace as far back as 2006, but instead of mandating a wholesale cleanup and imposing extensive fines, it chose to let Wall Street off with barely a wrist slap.

It also can be argued that the SEC might have prevented the collapse of Bear Stearns. It’s publicly known that the SEC dropped an investigation of Bear’s valuations of collateralized debt obligations just months before the firm collapsed. We now know those valuations weren’t worth the paper they were printed on.

Sen. Charles Grassley, the ranking member of the Senate Finance Committee, admirably and justifiably wants to know why the SEC dropped its Bear investigation. But according to today’s Wall Street Journal, the SEC responded to the Senator as if he was just a reporter.

“The commission does not disclose the existence or nonexistence of an investigation or information generated in any investigation unless made a matter of public record in proceeding before the Commission or the courts,” the SEC responded in a letter.

It doesn’t take a rocket scientist to figure out what’s going on here. The SEC’s decision to close its Bear investigation represents yet another monumental agency failure. The agency knows full well that Congress will be outraged if the truth about its failure to protect investors becomes publicly known. Let’s hope that Senator Grassley is sufficiently outraged by the SEC’s response and continues to aggressively pursue this matter. The findings won’t be pretty, but maybe it will finally lead to some real – and much needed – regulatory reform.

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Wednesday, April 09, 2008

Auction Rate Securities Compensation: Peanuts or Icing on the Cake for Brokers?

Dow Jones (no link available) touches today on an issue I’ve covered in my blog often: Wall Street’s compensation tied to the auction rate securities (ARS) market. Wall Street is claiming that “they picked these products because they offered higher yield for investors than other cash-like products, not because they generated fees for brokers.”

When compared to stocks and mutual funds, the compensation to brokers is marginal. However comparing ARS investments to mutual funds and stocks is flawed; a better comparison is to other so-called “cash equivalents” such as Treasury’s and money-market funds, which as Dow Jones states, “pay little to nothing.”

Whether the fees were as marginal as Wall Street claims remains debatable. One broker, Dow Jones reports, earned $5 for every $25,000’s worth of ARSs he sells plus a “trailer,” which is an annual fee of about 0.12 percent. That fee structure is consistent with our understanding.

But here’s the twist: we’re getting calls from corporations and high net worth individuals with $100 million invested in ARSs. Under this scenario, the broker would have earned a trailer/annual fee of $120,000 or more from this ARS client alone. If this client would have been placed in Treasuries, the fees would have been drastically lower. Peanuts? Or nice ten percent boost to a broker earning $1 million annually?

Admittedly it seems counterintuitive to me that a broker would risk his or her prized high-net worth and corporate clients by placing them in ARSs when they sought cash equivalents. Though I’d never underestimated Wall Street’s “need for fees,” it’s plausible that brokers were themselves duped by their own firms.

Here’s why:

A broker's Wall Street employer is paid for managing an ARS auction by the issuer - usually around one percent of the total securities auctioned. So, for example if a municipality issues $300 million worth of auction rate securities, the firm that manages the auction earns $3 million. Numerous auctions were being held daily so these fees racked up. Since the market is estimated to be $330 billion, conservatively Wall Street raked in over $3 billion in fees. An extra few hundred million - to borrow a quote from Jeffrey Skilling - is enough to “juice earnings” at least. And the manager overseeing a firm’s auctions' compensation is likely tied to the amount of fees generated too.

The auction fees could be a reason why ARSs were pitched so heavily to investors. Some brokers were at best naïve participants. But ignorance, while blissful, is not a justifiable argument. A broker has a fiduciary responsibility to inform a client of an investment’s risks. It doesn’t take an economist to realize that along with ARS’s higher returns there are greater risks, particularly liquidity. Clients should have been made aware that at any given time, Wall Street could pull out of the bidding process and freeze the market, instantly turning what was a highly liquid asset into a 30-year, low interest fixed rate bond.

I simply don’t buy into the argument that fees did not factor into the decision to put clients into ARS. Fees were small in comparison to other investments…ok…but clearly enough of an incentive to feed Wall Street’s greed machine.

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Monday, April 07, 2008

Fortune's Must Read Articles on the Wall Street Bailout

If you don’t subscribe to Fortune, I strongly recommend forking out five bucks and buying the latest issue on how to fix Wall Street. Bethany McLean’s column alone is well worth a Lincoln.

Ms. McLean, who is best known as the reporter to first sound the alarm about Enron, revisits a McKinsey & Co. report issued approximately a year ago saying that regulatory burdens were hindering the competitiveness of the U.S. markets. These lines are worth quoting verbatim:

“McKinsey wrote that over-the-counter derivatives “help foster the kind of continuous innovation that contributes heavily to financial services leadership.” (Tell that to Bear Stearns.) McKinsey also complained that higher capital requirements for U.S. banks would put them at a “competitive disadvantage.” (Hello, Citigroup!).

Ms. McLean notes that the McKinsey report was backed by New York Senator Chuck Schumer, who now believes that more regulation is needed. Ms. McLean is extremely charitable; she might also have noted that the folks at McKinsey also celebrated Enron for that company’s innovation before it collapsed as well.

Shawn Tully’s article “What’s Wrong With Wall Street and How to Fix It,” is a first-piece of expository journalism and deftly explains the inner and conflicted workings of Wall Street. His explanation of the reckless risks Wall Street firms take with leverage is especially impressive: According to Tully, since 2002, the leverage of the five biggest Wall Street firms, measured by assets as a multiple of equity, jumped to 41 from 30. That means if a firm’s portfolio is leveraged at 33 to 1, it takes a mere 3% drop to wipe out its entire capital.

Mr. Tully admirably reports as fact an open secret that has long been known: Wall Street firms use intelligence they get from executing institutional client trades for their own trading benefit. The “intelligence” is euphemistically known as “color.” Mr. Tully says the rise of automated trading makes it easier for big institutional clients to trade anonymously, but experts in algorithmic trading I’ve spoken with say that’s not necessarily the case. Still, I commend Mr. Tully for his insightful piece of analysis.

Finally, legendary columnist Allan Sloan weighs in with a commentary that if every American taxpayer were required to read, Congress would be forced to clean up Wall Street once and for all.

Still, I have one quibble with Fortune’s latest issue: It doesn’t examine the formidable obstacles individual investors face getting retribution for Wall Street’s wrongdoing. The subject matter could easily fill an entire issue.

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Tuesday, April 01, 2008

Paulson Proposal Neglects Individual Investors

By any measure, Paulson’s plan shows a certain disregard for individual investors, who have suffered the brunt of Wall Street’s extensive wrongdoings of the past few years. The plan neglects the pressing need to bolster investor protections for individual investors and threatens to usurp the authority of state regulators, who have a very impressive record of pursuing Wall Street wrongdoing. The plan’s only beneficiary is Wall Street, which has long wanted more streamlined regulation because it would ease their regulatory burdens.

Another area that Paulson neglected to cover was investor arbitration, which many have argued favors brokerage firms. It would have been helpful for him to propose reforms that would level the playing field for investors who are required to arbitrate disputes with their brokers.

But there also needs to be in place a regulatory mechanism that protects investors from wrongdoing before it occurs. Though in theory I have no problem with the creation of a “supercop” role for the Fed, Congress should insist that the expanded agency have a very senior investor advocate with extensive powers and authority. This advocate should have bona fide credentials representing individual investors and not be someone with close ties to Wall Street firms.

Finally, state regulators should continue to be allowed to regulate Wall Street firms doing business within their borders. State regulators such as state attorney generals have an important role to counterbalance federal regulators.

Ironically, I’m in Washington today to attend the North American Securities Administers Association (NASAA) annual meeting, an organization comprised of state regulators. I know I don’t have to tell you the dominant topic of conversation. NASAA’s comments on Paulson’s plan can be seen here.

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