The S&P 500 closed at 1,342 on Feb 10. It was at that level in May 2008, January 2001 and June 1999. For nearly 13 years, investors in America’s largest companies have essentially made little return on their investments.
But think about all the multi-millionaires and billionaires Wall Street has created f rom within its own ranks in that time span! It’s almost as if the game is rigged against the small investor.
Unfortunately, it is.
M.F. Global, for example, pledged and lost its clients’ assets in a bet on Italian bonds. Had the bet paid off, the firm and its management stood to benefit, not the clients. Yet the clients were on the hook when the bet went sour. In 2009, the government used taxpayer dollars to save the “Too Big To Fail” banks (which have since grown by more than 25 percent), or those in trouble because they had grossly over-levered their balance sheets. As if nothing had happened, in 2010 these institutions paid their management record bonuses ($1 million is chump change).
There is story after story in the investment world of small investors being bilked out of their hard-earned assets. It’s largely due
to a system that always puts the clients last. Here are some examples:
Outside Managers: Oftentimes, broker/dealers and/or supposed investment firms send client assets to outside managers. The client has to pay double fees – one set to the investment firm and another set to the outside manager. The outside managers often rebate part of their fees and expenses to the investment firm. Worse, the outside managers direct their discretionary purchases and sales, especially in bonds, back to the introducing firm’s trading desk. That desk, knowing full well there will be no competitive bid from other trading desks, adds a significant mark up or down from the true market price.
Shelf Space: In order to be available to clients, the large broker/dealers require smaller mutual funds to pay a monthly fee. In addition, all of the funds must rebate to the broker/dealer all or part of the 12b-1 fee that they charge as part of their expenses where these are split between the firm and the account rep.
In today’s world, there is absolutely no reason to pay a front end or back end “load” for a mutual fund. Yet many clients of the large broker/dealers pay loads as high as 5 percent, much of which is retained by the broker/dealer. If you are being charged a “load” when you buy mutual funds, ask yourself if your interests are being put first. Vanguard funds are widely known for having no loads (or 12b- 1 fees) and their expense ratios are among the lowest in the industry. Ask your account rep if you can buy Vanguard funds in your account. If the answer is no, consider whose interests are being put first.
Inappropriate Investments: This is really the biggest issue for small investors. Because of the cost of litigation, most small investors who have lost significant sums due to inappropriate investments cannot afford to fight a legal battle to recoup losses. Most of the time, inappropriate investments occur because the fee to the selling agent or institution is so significant that the clients’ best interests are put behind those of the firm or the account rep. A good practice is to ask your account rep the amount of commission associated with any particular trade.
The accompanying news story about Bobby Hayes of Incline Village, his local attorney, Thomas Bradley, and his broker/dealer Merrill Lynch (now Banc of America Securities) illustrates many of these points:
• In July 2007, Mr. Hayes told his account rep he didn’t want to take any risk with $883,122. His account rep put him into a high risk tranche of a collateralized mortgage obligation. If the value of the assets in the tranche fell by as little as 0.5 percent, Mr. Hayes’ investment would be wiped out. (During the last decade, Wall Street’s financial “rocket scientists” divided up the cash flows from mortgages such that some tranches were quite secure while others were quite risky. Guess which one Mr. Hayes got?) Did his account rep have any idea about the risk inherent in this investment? If the account rep did, he/she clearly violated his/her fiduciary duty to the client, as minimal due diligence (i.e., a call to the New York desk) would have uncovered the risk. Most likely, the account rep was blinded by the large ($37,000) fee associated with the sale of the tranche.
• As it turns out, the loans Merrill Lynch placed into the tranche had already fallen in value by 5 percent before the investment was sold to Mr. Hayes. The investment was worthless at inception. Worse, it looks like the folks at Merrill Lynch who issued the paper knew it.
• After more than five years, arbitrators awarded Mr. Hayes $218,000 in attorney fees. In addition, Hayes had to shell out $23,500 in other costs and was potentially liable for $8,400 in hearing fees.
• Hayes won the return of his investment, interest on it, attorney fees and the other costs, or about $1.38 million, because it was clear, even to the arbitrators, that the paper sold to him was worthless before it was purchased on his behalf and that Merrill Lynch most likely knew it. Yet despite the apparent fraud and Merrill Lynch’s shunning of its fiduciary duties to the client, no punitive damages were awarded. This speaks to the inherent bias against the investor and for the broker/dealer, which appears to permeate the system when it comes to Wall Street.
• It is interesting to note there were two such tranches, one for U.S. clients and another for foreign clients. Mr. Hayes purchased the entire U.S. tranche. The foreign investors, who purchased the other tranche, also sued and settled for an undisclosed amount. Of further interest in this case is that the Massachusetts Secretary of State has subpoenaed the same or similar records to see if Merrill Lynch knowingly overvalued assets it put into investment pools (“Galvin demands B of A records on mortgages,” www. BostonHerald.com on Feb. 11).
• Mr. Hayes’ attorney, Reno’s Thomas Bradley, has written about other inappropriate investments being foisted on unsuspecting small investors, usually because the commissions on the sales of such instruments are high (see http://blog. stockmarketattorney.com/many-investors- mislead-by-brokerage-firms-to- purchase-unlisted-reits.html).
From a lack of any real return to unconscionable fees and costs to an unaffordable and often unjust litigation process, the Wall Street system is rigged against the small investor. Just think of how many small investors were put into similar investments by Wall Street’s major broker/dealers. Few of them have the assets or stamina to fight Wall Street like Mr. Hayes did.
Most, if they actually do pursue legal action, settle for pennies on the dollar because of the costs, effort, and additional potential loss should the arbitrators rule against them.
Despite these abuses, the government continues to come to Wall Street’s aid. No one yet has gone to prison over the sub- prime fiasco. No one is likely to go to prison in the M.F. Global scam. Despite the obvious fraud, no punitive damages were assessed in the Hayes case.
U.S. households have $700 billion in negative equity in their homes, and the government (who had its own fingers in the mortgage fiasco) last week settled with the biggest perpetrators for 3.5 cents on the dollar. With only slaps on the wrist and minor fines or penalties for fraudulent behavior and the shirking of fiduciary obligations, what will incent Wall Street to alter its behavior?
Conclusion: Little is going to change for small investors in America unless and until the Wall Street playing field is leveled.
Robert Barone, Ph.D.
