US Financial Crisis: Selling Two Legged Stools

Many people ask me how the financial sector got so messed up. Here is the best analogy I can give you:

Imagine a world where stools are a critical component to the economy. Stupendous Stool Store, Inc (SSS) is one of the five largest stool companies in the world. For years, SSS sold four legged stools with various degrees of quality to retail stores

worldwide. SSS sells its stools in bundles of 10, improving efficiency and lowering costs. They bundle together both high and low quality stools to give the retailer a nice mix to sell to consumers. For many years, this was a very profitable business.

One day, the SEC (Stool Exchange Commission) relaxed the capital requirement laws for companies like SSS. Before, they could only borrow 10 times their equity for the inventory needed to make the stools. Now they could borrow 40 times their equity to purchase and make stools for repackaging. SSS set up more lines of credit to purchase more raw materials to make more stools. In order to carry this new debt load, SSS needed to make lower cost stools. One highly paid executive at SSS decided that they could lower prices of the stools, by including a few three legged stools in their bundles. They modeled the use of the new stool by sending “Stool Samples” to various bars and pubs around the world. They quickly determined that the three legged stool is just as good as a four legged stool, but costs less to make and takes up less room. Buyers of the stools did not seem to mind at all.

SSS then sent the Stool Samples to their independent external rating agency, Dumb and Dumber, Inc. After speaking with the executives at SSS and reviewing their “Stool Samples”, those at Dumb and Dumber, Inc. concluded that the new stool bundles should receive the same AAA rating as before. Now SSS could sell both three and four legged stools in bundles for the same price as they sold a bundle of higher quality four legged stools. The executives and sales people at SSS pocketed the additional profits and were happy.

Then one of the highly paid commission sales persons at SSS came up with an even better idea. How about adding some 2 legged stools to the package? These stools would only be effective for sober customers with good balance. Since they are only going to put a few of these stools in each bundle, along with three and four legged stools, they were able to lower their costs yet again. They went to Dumb and Dumber, Inc. with their “Stool Samples” and explained that since 20% of the customers who buy stools were sober, the two legged stools really had no effect on the quality of the stool package. Those at Dumb and Dumber, Inc. agreed and rated the stools packages AAA yet again. SSS could sell its stool package at the same price as before, but with much lower costs and pocket a handsome profit.

In order to keep production going, SSS always maxed out its leverage so that it had plenty of Stool Bundles available for the market. Eventually however, the stools reached a saturation point in the market and sales began to decline. At the same time, people were getting hurt falling off the three and two legged stools. Some companies began to return their stool bundles and others simply stopped buying.

It was at this point that Dumb and Dumber decided to lower the rating of the Stool Packages from AAA to BBB. Now no one wanted to buy any stools from SSS. SSS was still holding forty times its equity in lower rated stool packages in its inventory. These Packages were now “marked to market” by SSS’s auditor, an arbitrary process used to kick you when you are down. When they are marked down just 4%, the entire equity of SSS is wiped out. It is about this time that the banks that lent money to SSS began calling in their loans. They wanted their money back. At the same time, giant hedge funds began shorting the SSS stock, hammering its value even further. Eventually SSS had to either declare bankruptcy, be forced into a shotgun marriage with a stronger company, be taken over by the government or, as an interim step, be converted to a bank to be taken over later.

Imagine now that there are two legged stools hidden in dark pubs around the globe. They are owned by various institutions who no longer want them and the stools cannot be valued. As you can see, the world would be in quite a pickle if we relied on stools as a major source of financial security.

I used the stool in this analogy for two reasons. First, for many years, banking decisions were made by analyzing the 4 “C’s” of lending. Think of these 4 “C’s” as the 4 legs of a stool. They are Character, Cash Flow, Credit and Collateral. In residential lending, character was eliminated some time ago when loans were securitized and borrowers and their ultimate lenders never met. That left a three legged stool that functioned pretty well through the 1990s. However, in the first few years of the new millennium, new products were coming out that eliminated one of the remaining legs of the stool. No income verification loans, no down payment loans, and loans to people who exhibited poor credit decisions were created. Soon the three legged stools became two or even one legged stools. They were then packaged and sold and somehow obtained AAA ratings.

Loose lending guidelines combined with leverage and poor regulation has been the recipe for an unprecedented financial meltdown in this country. The mortgage back securities created by these firms have filled our financial institutions with financial crap; the second reason for my “stool” analogy.

Who Does Your Financial Adviser Represent?

In a world of uncertainty, where one hundred and fifty year old financial institutions declare bankruptcy or are seized by the government over night, it becomes crucial for investors to understand who the advisers handling their money represent. Does their financial adviser put their clients’ interests above those of their own and their company, or are they simply selling them the recommended investment product du jour.

In 2008, customers of UBS, Merrill Lynch, Wachovia, Bank of America, and other larger financial institutions were shocked to find that their savings were locked up or wiped out when their “safe” option rate securities were no longer liquid. They were “sold” these products by their trusted advisers as an alternative to money markets. Meanwhile, their companies were being paid to create these securities. These companies were sued by their customers and several state attorneys' general and forced to pay for any losses incurred.

Others are now being told by their investment advisers that variable annuities are an excellent alternative for investing. These annuities offer a minimum “guaranty” of principal invested so that when the market goes down, “your money is still safe”. Thus, if you invest $100,000 and wait ten years past the penalty period, you will be “guaranteed” at least your money back. Why were these products not offered before the market collapsed? What are the costs associated with them? How good is the “guaranty” when companies as large as AIG can fail?

The people dispensing financial advice are split primarily into to two camps; those that have a legal fiduciary relationship to their employer, and those that have a fiduciary relationship to their client.

Fiduciary Relationship Lies With Employer or Broker Dealer

Financial Advisors that have a fiduciary relationship to their employer are called “Registered Representatives”. They are registered with their broker dealer, usually their employer, which they represent. They carry cards with such titles as “Financial Advisor”, “Investment Advisor”, “Financial Consultant”, “Financial Planner”, “Registered Representative”, “Insurance Agent”, and many others. In most cases, they work for large brokerage firms like Lehman Brothers, Bear Sterns, Merrill Lynch, Morgan Stanley, just to name a few. Some work for insurance companies such as AIG or banks such as Washington Mutual or Wachovia. These advisers generally carry Series 7 and insurance licenses so that they can legally receive commissions or referral fees on products they sell.

These individuals are tasked with selling products their organizations have created or recommend to their customers. Their regulator is the National Association of Securities Dealers, or the NASD. According to Scott Simon, author of the Prudent Investor Act: A Guide to Understanding, “registered reps follow the “suitability” standard under NASD regulations. This standard doesn’t require a registered rep to place the interests of its clients ahead of its own. Under this non-fiduciary suitability standard, a registered rep need provide only “suitable” advice to its clients-even if it knows that the advice is not the best advice.”

As Liz Pullium West, author of Easy Money: How to Simplify Your Finances and Get What You Want Out of Life, puts it, “At best, they're held to a "suitability" standard, which means they're supposed to reasonably believe that the investment and insurance products they want you to buy are appropriate for your situation. Just "appropriate" -- not "the best choice" or "in your best interests." Let's say you have $10,000 a year to save for retirement. Your financial adviser could recommend you invest the money in a low-cost index fund that might net you a return of 8% a year. After 30 years you'd have over $1.1 million. But let's say the adviser could earn a fat commission for recommending a higher-cost investment being promoted by his financial-services firm. So instead of netting 8% a year, you might net 6%. After 30 years, your nest egg would grow to just under $800,000, a difference of more than $300,000. The high-cost investment might be perfectly "suitable," since it meets your financial objective of saving for retirement, even if it could leave you significantly poorer than had you invested in the index fund.”

Merrill Lynch has gone to court to defend this concept of having a fiduciary duty to the company instead of the client. In an attempt to have its cake and eat it too, Merrill Lynch was able to get a court ruling, now called the “Merrill Lynch Rule”, to allow them to operate like a true advisor to the client while still representing the firm. This rule was overturned in 2007.

Fiduciary Relationship Lies with the Client

The second camp of investment advisors are Registered Investment Advisors (RIAs). Under the law, these advisers have a fiduciary duty to their client. They must register with the Securities Exchange Commission (SEC) once they have over $25 million under management. According to Mr. Simon, “Given its fiduciary status, an RIA must follow the “trust” standard- the highest known in the law-which requires it to place the interest of its clients ahead of its own and fulfill critical fiduciary duties…” Most hold the Certified Financial Planner designation which has its own separate “code of ethics”. Unless they are also a “registered representative”, they do not receive commissions or referral fess for investments they recommend. As a fiduciary, they have clients rather than customers. The have no incentive to select products based on commission paid nor are they required to provide specific investment products by their employer. They are free to select the best investments for their clients based on what is best for the client.

So why do so many wealthy individuals take the advice of those that represent their company rather than their client? The answer is the implied additional security combined with the sales power of a large firm. Here is a quick comparison of the financials of Charles Schwab and Merrill Lynch as of June 30, 2008:


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According to Wikipedia, “leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified and/or enhanced. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity.” ML is levered up 60 times! This is a primary cause of its forced sale to Bank of America.

With an increasingly complex financial world it becomes more important than ever to seek sound advice. Just make sure that advice comes from a professional who puts your interests first.

Book Review: Hot, Flat and Crowded

by Thomas L. Friedman

This is Friedman’s sequel to his widely popular book, The World is Flat. Friedman explains that the old problems of the cold war have been replaced by a host of new problems in what he terms the “Energy Climate Era”. Friedman argues, “We can no longer expect to enjoy peace and security, economic growth and human rights if we continue to ignore the key problems of this new era. These new problems include:

• Energy Supply and Demand
• Petro Dictatorship
• Climate Change
• Energy Poverty
• Biodiversity Loss

Friedman describes these problems in detail and precisely how we can solve them. If you want to learn how we can make the planet a better place for our children, this is a must read.

Market Update

Today’s investment environment is reminiscent of a recent article on fox hunting by Dominic Bliss of The Financial Times, entitled “Manhunt”. Since fox hunting has been banned in England and Wales since 2004, Bliss went to Blackpool England to see how things have changed. She described the modern day fox hunt as follows:

“At Peagram's Farm [Blackpool, England], 35 excited riders - the huntsmen in smart red jackets, the rest in black or tweed - are waiting for the hunt to start. They sip port and sherry to brace themselves against the wind coming in off the Irish Sea, while their finely groomed horses jig their heads and stamp their hooves.

Below them, whining and barking in anticipation, is a pack of about two dozen bloodhounds. Mingling with the dogs, and looking decidedly apprehensive, are two "foxes" - Richard Davies, a 49-year-old civil servant from Kirkham, and Matthew Ray, a 32-year-old (off-duty) journalist from Brighton. Both are accomplished athletes.

As they pet the hounds, allowing the animals to memorize their scent, the master huntsman Clive Richardson offers a few words of encouragement. "Don't worry," he says. "When a limb's torn from you, it really doesn't bleed that much."

I believe many investors feel a little like the human quarry in this fox hunt as they try to navigate the financial wreckage that was third quarter of 2008. This historic quarter will be found in the next generation’s financial and history text books. It is a period when companies recently valued at a combined $500 billion vaporized. It is a time when the oldest money market fund “broke the buck” and fell below $1.00. A period when people were willing to buy US Treasury Bills for more than they would be re-paid after holding them for 1 month. It also marks the creation of the world's largest sovereign wealth fund, the US Treasury.

For the quarter, the S&P 500, the index which holds the 500 largest companies in America, was down 9% and down 20% for the year to date. More alarming is that the S&P 500 is up only 2.8% for 10 years. Investing internationally did not help with this bear market. The EAFE index was down 21% for the quarter and 31% for the year to date! Emerging markets where especially hammered, with the EM index down 27% and 37% year to date. The bond market, which usually moves in the opposite direction as equities also fell 0.6% for the quarter and was up only 0.5% for the year to date.

Is there a silver lining in all this bad news? Yes. Recessionary environments and market corrections are the best time to make smart investments. Today, everything is on sale. The question of the day is, "Will there be a “clearance” tomorrow?” The key to navigating this mess is to focus on the long run. If your investment horizon is seven years or longer and you can handle the risks of the market fluctuations, this may prove to be the best time to invest in a generation.

Sector Performance Report

As of September 30, 2008

Nowhere to Hide: All sectors were down in the past 12 months with telecom getting hit the hardest. In the past three months, Consumer Staples, Financials and Health Care were the only sectors that did not fall. Expect that trend to continue over the coming year.



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