Elder Abuse with Principal-Protected Notes?

You would never know it from the online version of the March/April issue of AARP's magazine, but the print edition contains a scathing article on structured products – principal-protected notes. Pick up a copy and read "The Time Bomb in Your Nest Egg."

Brokers at major banks and Wall Street firms sold over $51 billion of the derivatives last year, typically to elderly investors seeking more income. One commentator refers to the structured products as the consumer version of the toxic derivatives Wall Street used to sell to institutions.

Sold under such fancy names as reverse-convertible or return-optimization securities, the products are so profitable for banks that in-bank brokers can earn commissions of from 3 percent to 10 percent, according to the AARP article. Seniors tend to be easy marks because "elderly people are often more comfortable with brokers who work in their banks."

The in-bank brokers I've run into over the years have seemed pleasant enough. I hate to see their brethren getting more bad press. Come to think of it, though, our local bank branch (TD Bank) recently cleared away the marketing materials for in-bank investment sales. Now the brochures promote TD Ameritrade.

Are some banks deciding that in-bank sales of investment products are not worth risking charges of elder abuse?

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Today's poster child for elder abuse was Mickey Rooney. This article on Mickey's Senate appearance includes a troubling statistic:

About 7.3 million older Americans — or one of every five people over 65 — have been financially swindled, according to an Investor Protection Trust survey ….

Such statistics seem to vary widely, along with definitions of a swindle.

Do “Sophisticated Solutions” Still Have Appeal?

Watched Michael Lewis, author of "The Big Short," on Sixty Minutes Sunday evening. (if you missed him, this blog has links to the interview.) While Lewis talked of "mass delusion" among Wall Street's best and brightest, I started reading a Northern Trust ad in the NY Times Sunday Magazine. The copy invites readers to see Northern for "a plan using … sophisticated strategies and solutions."

"No Thanks!" I thought. A number of "sophisticated" hedge funds and private-equity deals have gone down in flames. And let's not even talk about offshore tax shelters. If I had $10 million or $20 million, I'd be trying to simplify my financial life, not looking for sophisticated solutions.

That's probably one reason I'm not rich. After fighting to withdraw their money from hedge funds over the past two years, I read in the WSJ, investors are now putting their cash back in.

Hope beats experience every time.

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Speaking of Michael Lewis, don't fail to read the Harvard undergrad's thesis on CDOs that he commends in his book. From what I've read so far, it's lucid and, in places, scary. (Why anyone still pays attention to what the bond-rating firms say, after they declared sliced-and-diced toxic mortgage bundles to be triple-A bonds, is beyond me.) WSJ subscribers can read about the remarkable author here.

“Mortgage Modification” Leads to Tranche Warfare, then Court

Wall Street started moving to Greenwich and Stamford in Connecticut after 9/11. Staff had an easy commute from Grand Central; honchos got to live near their Greenwich megahomes. Recent arrival: Royal Bank of Scotland's massive new trading arena.

Reporter Teri Buhl has the good luck to cover the Greenwich and Stamford goings-on. Here she offers a close-up example of why the subprime mortgage mess is so difficult to clean up: Tranche warfare goes to court.

Stories such as this reinforce the notion that there are two types of people: Those who admit they don't understand derivatives and liars.

CDOs Cubed

From Floyd Norris' column in The New York Times:

MBIA is suing Merrill Lynch, which paid MBIA to insure securities backed by extraordinarily complex securities, among them collateralized debt obligations secured by collateralized debt obligations secured by collateralized debt obligations that were secured by mortgage-backed securities. Such a thing is known as a C.D.O. cubed . . . .

No comment necessary.

Seniors! Beware of Financial Alchemists

The Alchemist, via Wikimedia Commons

"[C]reating investments that promise investors both gains and protections is essentially like trying to work alchemy in the financial markets," observes The Wall Street Journal.

Despite last year's setbacks, the alchemists are back in their laboratories, seeking to turn derivatives into gold and stocks into investments that always go up.

The Journal reports they hope to sell their inventions to seniors – retirement-age investors.

(Advice from this senior to his peers: "Be afraid. Be very afraid.")

The Economist Reports on the Rich

Brother, can you spare $10 trillion?

In the Wealth Report, Robert Frank headlines the estimated $10 trillion that the world's rich have lost in the credit crisis, according to The Economist's Special Report on the Rich.

Happily, as the chart shows, there are plenty more trillions for wealth managers to fight over.

In Servicing the Rich, The Economist's Philip Coggan cites anecdotal evidence that most of today's rich either don't use private wealth managers or don't trust them.

Investment performance? That's a hard sell. Coggan explains why with the very same excuses I was stringing together for Merrill Anderson's clients decades ago:

Ask for performance figures, and the best you will get is the record of some model portfolio; clients are all different, managers say, and have different attitudes to risk. Besides, they argue, looking after a client is not just about performance, it is also about tax management, family structures and all manner of other things. Some clients have strong opinions and will want a say in how the portfolio is run; others will have long-standing positions in particular businesses or properties that they may be unwilling or unable to sell.

The carrots many wealth managers dangled before their prospective clients in the boom years were "alternative investments." Some turned out to be not such a good idea:

An important development in recent years has been the use of so-called structured products. Like the toxic versions that were undone by the collapse in the American housing market, these products involve the use of derivatives. That makes them a tempting sales opportunity for investment banks with derivative expertise. An enthusiast would say that these products often have tax advantages and can be used to manage an investor’s risk profile; a cynic would say that the structures can disguise a lot of fees and charges.…

But the bigger problem has been investment losses. During the boom years some Asian private-banking clients were sold a toxic product known as an accumulator. The structure sounded simple. If shares in a company, say General Electric, stayed above a given level, investors received a high yield; if the shares dropped below that level, they ended up owning the stock. In effect, the clients had written a put option on the share price. That was fine in rising markets but proved to be a disaster in 2008 when clients ended up owning shares that were falling rapidly.

Wealth managers will share some of their clients' pain, says Coggan: "Downward pressure on fees seems inevitable."

Lanchester Explains Derivatives

A surprising number of visitors to this blog are drawn by a post from last June: Mortgage Derivatives Explained. The post links to a whimsical poem by Shel Silverstein – enlightening, but probably lacking the information the visitor seeks.

Here's a better bet: Melting into Air, John Lanchester's New Yorker article, explains the abstractions known as derivatives and why we are not meant to understand them:

[F]inance, like other forms of human behavior, underwent a change in the twentieth century, a shift equivalent to the emergence of modernism in the arts—a break with common sense, a turn toward self-referentiality and abstraction and notions that couldn’t be explained in workaday English. In poetry, this moment took place with the publication of “The Waste Land.” In classical music, it was, perhaps, the première of “The Rite of Spring.” Jazz, dance, architecture, painting—all had comparable moments. The moment in finance came in 1973, with the publication of a paper in the Journal of Political Economy titled “The Pricing of Options and Corporate Liabilities,” by Fischer Black and Myron Scholes.

Lanchester points out that some people did foresee the collapse of the "financial economy." They even wrote books about it.

Mortgage Derivatives Explained

Long ago and far away, in my Army days, the Pacific Stars and Stripes had a clever cartoonist named Shel Silverstein. He went on to modest fame in several fields, including the authoring and illustrating of childrens' books and songwriting ("A Boy Named Sue").

In a post on the Marketbeat blog, Jon Hilsenrath suggests the slicing and dicing of mortgage loans and other debt by Wall Street's intripid financial engineers is best explained by a poem Shel once wrote.

Entitled "Smart," the poem begins thusly:

My dad gave me one dollar bill
‘Cause I’m his smartest son,
And I swapped it for two shiny quarters
‘Cause two is more than one!
And then I took the quarters
And traded them to Lou
For three dimes — I guess he don’t know
That three is more than two!

Mr. Hilsenrath may be on to something.