Banks Stocks the Next Tech-Bubble?

It comes as no surprise that the subprime/credit crunch crisis has led to an increased level of securities class action filings. Research firm Cornerstone just released a report which shows the financial sector was the target of the most filings with 63 in the first half of 2008 alone. The research is an indication that many believe there are disclosure issues which led to inflated stock prices.

But another area of concern is that brokers made speculative plays in these stocks on behalf of their retail clients. Sensing a bottom, many brokers loaded up theirclients with stocks like Citigroup, Merrill Lynch and even Bear Stearns. Trying to catch a falling knife is not an appropriate recommendation for an investor with amoderate or conservative risk profile and we are seeing such complaints become more common.

Clearly, brokers fell asleep at the wheel on two levels: there was no reasonable basis for expecting the financial services industry was finished with its subprime write-downs unless they were duped nor was there any reasonable basis for many investors to buy financial stocks during the past year and a half.

During the tech-bubble, we filed many claims on behalf of investors whose brokers pushed them into bottom fishing for tech stocks that were rightly beaten down. This is another example of Wall Street’s history repeating itself.

Needless to say, any broker who recommended buying bank stocks in the past year and a half should be prepared to explain their rationale in an arbitration hearing.

FINRA Pilot Arbitration Program is a Step in the Right Direction

Yesterday FINRA announced a pilot program to do away with the financial services industry participant in arbitration panels. Rather, all three panelists will consist of an investor’s peers.

FINRA is to be commended for at least putting a toe in the water towards arbitration reform. Studies have shown investors believe that the panels are bias against them. And the statistics supports this.

This is long overdue but a pilot program is hopefully just the beginning. Rather than a small pilot program this should be rolled out on a wholesale basis.

There will be a surge of investor claims in the wake of the sub-prime/credit crisis, so leveling the playing field for investors should continue to be one of FINRA’s main focuses.

Frank Quattrone’s Utopia

I’m quite sure everyone will take Frank Quattrone’s recent comments about returning to his glory days of conflicts between research and investment banking at face value, but at the risk of indulging his attempt at a comeback I’ll address his flawed reasoning. Mr. Quattrone believes barring Wall Street’s research analysts from participating in investment banking deals is the reason the U.S.’ IPO market share has decreased. Not so.

Among the reasons there are less IPO’s are these:

Ø Stock exchange listing fees are way too high

Ø Document filings and compliance is expensive (not necessarily a bad thing in my opinion)

Ø Global corporations have chosen to list on their home country’s exchange

Now is not the time to scale back regulation especially when it pertains to conflicts of interest. Exhibit A is the ratings agencies. Many CDO’s and mortgage backed securities received coveted AAA bond ratings due in a large part because of a conflict between the need to generate fees from Wall Street and independent, reliable research.

The one point Mr. Quattrone is spot-on about is the fact that many of Wall Street’s best research analysts have migrated to the buy-side. The stark difference in opinion about Lehman Bros. David Einhorn had versus Wall Street shows just how wide the gap is. Frankly, the only folks that trust Wall Street research are small retail investors and injecting tech-bubble conflicts will only exacerbate the problem.

Needless to say, Mr. Quattrone’s utopia would only serve to enrich him and his ilk.

Mr.Cuomo: ARS Investors Don't Need a Spitzeresque Settlement

After learning that New York Attorney General Andrew Cuomo is set to bring charges against UBS related to their marketing of auction rate securities, I am of mixed emotions. On the one hand I am pleased that the scandal is resulting in complaints, but I am only cautiously optimistic that the charges and potential settlement will be in the investors’ best interest.

Don’t get me wrong, Mr. Cuomo’s action is certainly welcomed and clearly warranted. Auction rate securities were pitched to investors as cash equivalents and liquidity risks were hidden, which is why I was particularly pleased to see that Mr. Cuomo could file charges against individuals at UBS and seek a broad resolution for investors whose money is tied up in the ARS permafrost.

But a resolution is only as good as its terms and I have reservations that an eventual settlement won’t go far enough. Specifically, it is typical for Wall Street to settle these types of matters without admitting guilt or acknowledging responsibility. Wall Street steadfastly bargains for this because it limits their liability to investor claims. Recall that Eliot Spitzer’s global Wall Street settlement included this “out” clause and many investors lost arbitration claims because of it.

Another common occurrence during the Spitzer regime was Wall Street scapegoating. So long as Mr. Cuomo targets individuals, he should follow the trail as high as it leads and not allow Wall Street’s top brass to sacrifice a few bit players.

Moreover, a resolution that simply makes UBS customers “whole” also is a mistake. For many months ARS holders were prevented from participating in more lucrative investments and making large purchases, such as homes, automobiles and tuition payments. It is reasonable that they should be awarded damages for those lost opportunity costs. And finally, some investors are facing legal fees which should be paid for by UBS.

A UBS settlement could serve as a case study for other ARS investigations. Cuomo and other State securities regulators are investigating Citigroup, Merrill Lynch, J.P. Morgan Chase, Goldman Sachs, Wachovia and many other institutions for similar practices.

We’ve been through the era of headlines, photo-ops and slaps on the wrist. Mr. Cuomo has an opportunity to substantively alter the way in which Wall Street markets its products.

As I said, I am cautiously optimistic.

The Hapless Members of Citi’s ELKS Club

It’s only a hunch, but experience tells me you can soon expect to be reading a lot about “ELKS” and other structured investments in the business press.

The name evokes images of a hardy, austere and stable animal able to withstand the harsh elements of the forest. But not in this story. For some Citigroup customers, ELKS might conjure images of a broker who duped you into buying risky securities that were inappropriate with your investment goals.

Citi’s ELKS (equity linked security) product is a risky derivative instrument where an investor is offered a specified return on a structured security tied to an individual stock. Providing the stock maintains a minimum value, the guaranteed return is paid. If the stock ever falls below the minimum value (sometimes around 80 percent), the ELKS immediately convert into shares of that stock. Then if the price of the underlying stock declines, the investor could receive a stock worth much less than the initial investment.

Here’s the catch: ELKS offer potentially higher returns, but the downside risk is unlimited if the stock goes south. If the underlying stock happens to dramatically increase in value, the investor only gets the guaranteed return.

For Citigroup, it’s a classic case of “heads I win, tales you lose.” The bank charges investors an upfront commission to buy ELKS and likely earns additional profits through hedging. Not surprisingly, brokerage firms were aggressively peddling structured derivative products like ELKS to unsophisticated retail investors a few years back, prompting FINRA to warn member firms of concerns that customers didn’t understand the inherent risks.

There’s evidence that FINRA’s warnings weren’t heeded. I represent a retired couple over 80 whose Citi broker last year bought $300,000 worth of ELKS on their behalf. The ELKS were highly unsuitable for retirees simply looking to preserve capital. The highly volatile stocks my client’s ELKS were derived from included Yahoo!, Cemex and Sandisk. The couple has lost nearly a third of their principal as the underlying stock’s value plummeted.

Admittedly, I have only encountered one ELKS case so far, but many brokerages firms peddled similar products using monikers such as PACERS, STRIDES, SPARQS, and ELEMENTS. Some commentators were critical of me when I sounded the early alarm about auction rate securities, but that warning proved quite prescient. Recall, that the SEC uncovered wrongdoing in the ARS market in 2006, but the activity persisted. Sadly, I can’t help but suspect that the experience of my elderly clients with ELKS is not an isolated incident.

Stay tuned.

“My Take” on the SEC posted on BusinessWeek.com

A few weeks ago I sent a comment to BusinessWeek’s senior editor and blog contributor Diane Brady agreeing with an item she posted that questioned the usefulness of the SEC’s charges against former A.I.G. CEO Hank Greenberg. I was asked to elaborate on my position by BusinessWeek.com for their outside contributor column, “My Take,” which was posted last week.

I focused my essay on drawing attention to what I believe are the more crucial issues for the SEC’s including the collapse of Bear Stearns, the continuing inadequacy of equity research, investment banking fees and credit default swaps. Moreover, the SEC should work to alter Wall Street’s compensation structure in order to be aligned with the goals of its customers. To read my essay, please click here.

As it turns, my commentary struck a cord (or a nerve) with a great many BusinessWeek.com readers and it became one of highest trafficked and commented articles on their website. BusinessWeek.com editor-in-chief John Byrne was kind enough to memorialize the accomplishment with a blog post of his own.

Clearly I am not alone in my position that our financial regulators need to do a better job of looking after individual investors and instituting substantive change on Wall Street.