FEND Securities Expert Witness
5529 Bedford Avenue Los Angeles, CA 90056
3106493663 fendmase@ca.rr.com FEND Securities Expert Witness
Mason Alan Dinehart III Arbitrator - FEND Securities Expert Witness

COMMUNICATING PRIVATE PLACEMENTS VIA THE INTERNET - LEGALLY

 

ANALYST CONFLICTS

 

NETTING OUT THEORY

 

THE SUB-PRIME CRISIS

 

 

 

 

 

 

USE OF THE INTERNET FOR COMMUNICATING APPROVED PRIVATE

PLACEMENTS TO PRE-QUALIFIED INVESTORS

 

 

 

EXEMPT SECURITIES OFFERING ARE NEARING THE DAWN OF WHAT PROMISES TO BE A TRULY BRAVE NEW WORLD:  BEGINNING SEPTEMBER 23, 2013, NEW SEC RULE 506(C) WILL ALLOW ADVERTISING AND GENERAL SOLICITATION IN CERTAIN "PRIVATE" SECURITIES OFFERINGS.  IN ADDITION TO EXISTING REGULATION D REQUIREMENTS, THE NEW RULE 506 (C) EXEMPTION IS SUBJECT TO THREE IMPORT AND NEW COMPLIANCE PROVISOS AS PART OF THE JOBS ACT:

 

*  ALL PURCHASERS MUST BE "ACCREDITED INVESTORS"

*  THE ISSUER MUST TAKE "REASONABLE STEPS TO VERIFY" ACCREDITED INVESTOR STATUS,&

*NO "BAD ACTORS" AS DESCRIBED UNDER NEW SEC RULE 506 (C) MAY BE INVOLVED

 

REMEMBER, DODD FRANK CHANGED THE MINIMUM $1 MILLION NET WORTH REQUIREMENT TO NOW EXCLUDE THE HOME.  THE "BAD ACTOR" PROHIBITIONS OF NEW RULE 506 (C) APPLY TO ALL RULE 506 TRANSACTIONS - THOSE RELYING ON NEW RULE 506 (C) AND ALSO THOSE RELYING ON "OLD" RULE 506 (B) (I.E. PRIVATE OFFERINGS MADE WITHOUT ADVERTISING).  THE BAD ACTOR PROVISIONS OF RULE 506 (D) ALSO ARE EFFECTIVE ON SEPTEMBER 23, 2013.  .

 

THE OLD RULES

 

THE NOTION THAT THE WORLD WIDE WEB COULD PROVIDE A HOME FOR PRIVATE PLACEMENTS EXEMPT FROM SECURITIES ACT REGISTRATION MIGHT AT FIRST SOUND IMPOSSIBLE.  HOWEVER, THERE IS NO REASON THAT THE INTERNET SHOULD BE AN IMPOSSIBLE ARENA FOR PRIVATE PLACEMENTS SIMPLY BECAUSE OF ITS GLOBAL REACH.  IF THAT POTENTIAL REACH CAN BE IN FACT LIMITED TO A DISCREET GROUP OF SOPHISTICATED, RICH AND EXPERIENCED INVESTORS BY SCREENING AND MONITORING TECHNOLOGY, THE GROUP WOULD BE AKIN TO A SMALL RESTRICTED CLUB LOCATED INSIDE A GIANT HOTEL.

 

THE SEC FOR OVER A DECADE SANCTIONED THE USE OF THE REG D PRIVATE OFFERING EXEMPTION BY PRE-QUALIFICATION OF GROUPS OF ACCREDITED INVESTORS WHO WOULD RESPOND TO EXTENSIVE SOLICITATIONS BY FURNISHING EXTENSIVE FINANCIAL DATA.  (1)

 

IN A SIMILAR VEIN, THE SEC HAS TAKEN THE POSITION THAT THE PRE-QUALIFICATION OF A NUMBER OF ACCREDITED OR SOPHISTICATED INVESTORS ON A WEB SITE AND ELECTRONICALLY NOTIFYING THEM IN A SECURED MANNER OF SUBSEQUENT PRIVATE PLACEMENTS WOULD NOT INVOLVE A “GENERAL SOLICITATION:, AND THEREFORE WOULD ALLOW THE BUILDING OF INVESTOR DATA-BANKS FOR PRIVATE OFFERINGS UNDER SEC REGULATION D.  (2)

 

SECURED THIRD PARTY WEB-SITES MATCHING ENTREPRENEURS WITH ACCREDITED INVESTORS, WHERE THE SITE HAS ESTABLISHED PRE-EXISTING RELATIONSHIPS WITH ACCREDITED INVESTORS, IS GENERALLY PERMISSIBLE.  USE OF LARGE ACCREDITED INVESTOR LISTS, SUCH AS E-MAILS OR DIRECT MAILINGS, WOULD BE APPROPRIATE IF THE LIST OWNER HAS ESTABLISHED SUBSTANTIVE PRE-EXISTING RELATIONSHIPS WITH ACCREDITED INVESTORS.  THE STRONGER THE RELATIONSHIPS ESTABLISHED, THE BETTER.  FOR EXAMPLE, BUYING OR RENTING A LIST FROM A COMPANY OF ITS EXISTING PRE-EXISTING RELATIONSHIPS ARE NOT DETERMINATIVE.

 

THE FOLLOWING FACTORS SHOULD ALWAYS BE HEEDED: (1)  PRIOR TO VIEWING THE OFFERING, PROSPECTIVE INVESTORS SHOULD VERIFY THEIR ACCREDITED STATUS; (2) SAFEGUARDS SHOULD BE IN PLACE TO ENSURE ONLY THOSE TO WHOM THE SOLICITATION IS SENT ARE ABLE TO VIEW THE OFFERINGS.

IN APPROACHING THE GENERAL SOLICITATION QUESTION AS IT RELATES TO ONLINE OFFERINGS, THE SEC HAS FOCUSED ON BROKER-DEALER OPERATED WEBSITES AND THE

METHOD BY WHICH THEY QUALIFY THEIR CUSTOMERS.  AS NOTED, IT APPEARS THAT THE SEC HAS DEMONSTRATED CONSIDERABLE ACCEPTANCE OF ONLINE OFFERINGS OPERATED BY BROKER-DEALERS.  HOWEVER, THE SEC HAS ROUTINELY RESISTED PROVIDING NO-ACTION RELIEF TO NON-BROKER-DEALER WEBSITE OPERATORS.  IN DOING SO, THE SEC HAS REPEATEDLY RELIED UPON ITS HIGH COMFORT LEVEL WITH THE TRADITIONAL METHODS OF BROKER-DEALER FIRMS DESIGNED TO ESTABLISH A “PRE-EXISTING, SUBSTANTIVE” RELATIONSHIP WITH PROSPECTIVE INVESTORS.  THIS IS BECAUSE BROKER-DEALERS ARE REQUIRED UNDER THE SELF-GOVERNING FINRA RULES TO DEAL FAIRLY WITH, AND MAKE SUITABLE RECOMMENDATIONS TO, THEIR CUSTOMERS.  BUT REMEMBER THE SEC’S PLEDGE THAT THE ABSENCE OR PRESENCE OF A GENERAL SOLICITATION IS ALWAYS DETERMINED ON A CASE-BY-CASE-BASIS, TAKING INTO ACCOUNT ALL RELEVANT FACTS AND CIRCUMSTANCES.

 

BASED ON SEC RELEASE 33-7233, EXAMPLE 21, IT APPEARS THE SAFEST ONLINE PRIVATE OFFERING UNDER REGULATION D WILL INVOLVE: (A) A PASSWORD-PROTECTED WEBSITE (KNOWN AS A WEB-FRONT) DIRECTLY OPERATED BY A BROKER-DEALER FIRM (AS OPPOSED TO AN UNLICENSED THIRD PARTY), (B) USE OF A COMPREHENSIVE, GENERIC (NON-OFFERING SPECIFIC) PRE-SUITABILITY QUESTIONNAIRE THAT ELICITS SUFFICIENT INFORMATION TO PERMIT A THOROUGH EVALUATION OF THE PERSPECTIVE INVESTOR’S FINANCIAL STANDING, PAST PRIVATE PLACEMENT INVESTMENT EXPERIENCE  AND SOPHISTICATION LEVEL, AND (C) A REQUIREMENT THAT A SUFFICIENT AMOUNT OF TIME LAPSE BETWEEN THE RESPONSE TO THE QUESTIONNAIRE AND ACTUAL PARTICIPATION IN A PRIVATE OFFERING I.E. LAMP TECHNOLOGIES (MAY 29, 1997) (SEC RECOGNIZED A 30 DAY WAITING PERIOD AFTER THE QUALIFICATION OF THE INVESTORS.

 

WHILE THE TIME MAY COME WHEN THE SEC WILL TRULY EMBRACE AN ONLINE REGULATION D OFFERING SPONSORED BY A NON-BROKER-DEALER, CURRENTLY THE SEC HAS SHOWN PRACTICALLY NO SUPPORT FOR SUCH OFFERINGS.

 

LETS PROVIDE SOME BACKGROUND.

 

THE FUNDAMENTAL PREMISE OF A PRIVATE PLACEMENT COMES FROM SECTION 5 OF THE SECURITIES ACT FO 1933 WHEREBY, “IT IS UNLAWFUL FOR ANY PERSON TO SELL SECURITIES BY MAKING USE OF MEANS OR INSTRUMENTS OF TRANSPORTATION OR COMMUNICATION IN INTERSTATE COMMERCE UNLESS A REGISTRATION FOR THE SECURITIES HAS BEEN FILED WITH THE COMMISSION 15 U.S.C. #77(E).

 

 

 

 

THIS IS FURTHER STATED IN SECURITIES ACT RELEASE NO. 33-4552 (NOV. 6, 1962) – “NEGOTIATIONS OF CONVERSATIONS WITH OR GENERAL SOLICITATIONS OF AN UNRESTRICTED AND UNRELATED  GROUP OF PROSPECTIVE PURCHASERS FOR THE PURPOSE OF ASCERTAINING WHO WOULD BE WILLING TO ACCEPT AN OFFER OF SECURITIES IS INCONSISTENT WITH A CLAIM THAT THE TRANSACTION DOES NOT INVOLVE A PUBLIC OFFERING EVEN THOUGH ULTIMATELY THERE MAY ONLY BE A FEW KNOWLEDGEABLE PURCHASERS”.

 

THIS PROHIBITION OF A “GENERAL SOLICITATION APPLIES TO ANYONE ACTING ON BEHALF OF THE ISSUER I.E. A BROKER DEALER OR ITS REPRESENTATIVES.  SEC RULE RULE 502(C) PRECLUDES THE USE OF:

 

·       ANY ADVERTISEMENT, ARTICLE, NOTICE OR OTHER COMMUNICATION PUBLISHED IN ANY NEWSPAPER, MAGAZINE, OR SIMILAR MEDIA OR BROADCAST OVER TELEVISION OR RADIO, AND

·       ANY SEMINAR OR MEETING WHOSE ATTENDEES HAVE BEEN INVITED BY ANY SOLICITATION OR GENERAL ADVERTISING.

NO COLD CALLING IS PERMITTED.

 

TO AVOID ENGAGING IN A GENERAL SOLICITATION, ONE SHOULD:

 

·       LOOK TO THE EXISTENCE OF A SUBSTANTIVE RELATIONSHIP THAT EVIDENCES A PERSONS INVESTMENT SOPHISTICATION.  SEE E.G. E.F. HUTTON & CO. (AVIL. NOV. 3, 1985) (FINDING THAT BROKER-DEALERS COULD ENSURE RULE 502(C) COMPLIANCE BY ESTABLISHING A SUBSTANTIVE AND PRE-EXISTING RELATIONSHIP WITH THE OFFEREES) AND

 

·       USE OF QIB (QUALIFIED INSTITUTIONAL BUYER ) LISTS.

 

THE SEC DOES NOT CONDONE THE PRACTICE OF INVESTOR “SELF-CERTIFICATION” OF ACCREDITATION OF SOPHISTICATION ALONE, PRIOR TO GAINING ACCESS TO A PRIVATE OFFERING.  THERE HAS TO BE, IN ADDITION, A SUBSTANTIVE PRE-EXISTING RELATIONSHIP.

 

 

A BROKER-DEALER MAY ESTABLISH A PROGRAM OF CONTACTING PERSONS TO ESTABLISH A GROUP OF POTENTIAL CLIENTS WHO ARE ELIGIBLE TO PARTICIPATE IN FUTURE PRIVATE PLACEMENTS UNDER REGULATION D SO LONG AS:

 

 

 

     THE SOLICITATION IS GENERIC AND NOT MADE IN “CONTEMPLATION” OF AN OFFERING AND OFFERED SECURITIES BEING OFFERED, OR CONTEMPLATED FOR OFFERING, AT THE TIME OF THE INITIAL CONTACT:  AND

 

(A)    A SUBSTANTIVE RELATIONSHIP IS ESTABLISHED WITH THE CLIENT BETWEEN THE TIME OF THE INITIAL CONTACT AND THE LATER OFFERING.  (IT IS ESTIMATED THAT IF NO PERSON SOLICITED WOULD BE SENT ANY OFFERING MATERIALS WITHIN 45 DAYS AFTER THE DAY THAT THEY WERE INITIALLY CONTACTED, AND/OR WITHIN 30 DAYS OF BEING PROPERLY QUALIFIED, THAT WOULD SUFFICE).

 

 

PRIOR RELATIONSHIPS:

 

A.    THINK OF ALL THE GROUPS YOU BELONG TO OR ARE ASSOCIATED WITH, I.E. CHARITIES, REAL ESTATE OR STOCK INVESTMENT CLUBS, SERVICE CLUBS AND ASSOCIATIONS.

B.    BUILD A LIST QUICKLY FROM YOUR NETWORK OF FAMILY, FRIENDS, FORMER SCHOOLMATES, ASSOCIATES AND ORGANIZATIONS.  PEOPLE THAT YOU KNOW OR HAVE HAD PRIOR BUSINESS DEALINGS WITH, QUALIFY FOR THAT “PRIOR RELATIONSHIP” TEST.  YOU MUST KNOW OR DETERMINE SPECIFICS ABOUT THEIR FINANCIAL WHEREWITHAL I.E. INCOME, NET WORTH, INVESTMENT OBJECTIVES, RISK TOLERANCE AND PRIOR PRIVATE PLACEMENT INVESTMENT EXPERIENCE AND OVERALL INVESTING SOPHISTICATION.

C.    DEVELOP A PRE-SUITABILITY QUESTIONNAIRE TO DETERMINE THESE FACTORS (Exhibit C).  THIS FORM CAN BE USED WITH PROSPECTIVE INVESTORS TO HELP BUILD A PRE-EXISTING RELATIONSHIP.  THIS QUESTIONAIRRE MUST ASSURE PRIVACY AND CONFIDENTIALITY AND ASKS THE KIND OF QUESTIONS TO HELP DETERMINE IF THE INVESTOR MEETS THE SUITABILITY REQUIREMENTS OF THE OFFERING, ALLOWS YOU TO LEARN OF THE INVESTMENT OBJECTIVES AND PAST INVESTMENT EXPERIENCE OF THE POTENTIAL INVESTOR AND ESTABLISHES THE DATE THAT YOU FIRST MET THE PROSPECTIVE INVESTOR.  THE ESTABLISHMENT OF THE DATE IS IMPORTANT, AS THE PROSPECTIVE INVESTOR CANNOT PURCHASE UNITS IN A PRIVATE OFFERING THE BROKER DEALER HAS AVAILABLE ON THE DATE OR IS CONTEMPLATING AS OF THAT DATE.

 

 

 

 

     D,  YOUR LIST OF RELATIONSHIPS CAN BE EXPANDED VICARIOUSLY, BY ASKING YOUR LAWYER, ACCOUNTANT, AND/ OR BANKER TO MAKE MATERIAL AVAILABLE TO POTENTIALLY ACCREDITED PURCHASERS WITH WHOM THEY ARE ACQUAINTED.

 

     E.  KEEP GOOD RECORDS – DOCUMENT THE PRIOR SUBSTANTIVE PRE-EXISTING RELATIONSHIP.  IT IS CRITICAL TO KEEP CAREFUL RECORDS IDENTIFYING ALL OFFEREES, EVEN THOUGH THE NAMES DO NOT APPEAR ON A MASTER MAILING LIST.  IF AN INTERMEDIARY IS USED, IT IS IMPORTANT TO MEMORIALIZE THE INTERMEDIARY’S ACTIVITIES.  WITH GOOD RECORDS IT BECOMES EASIER TO PROVE THAT SOLICITATION WAS CONTROLLABLE AND NOT INDISCRIMINATE.

 

 

 

 

SEMINARS

 

 YOU MAY USE EMAIL, TELEPHONE, LETTERS OR BETTER YET AN EDUCATIONAL SEMINAR TO “INFORM” AND “QUALIFY” POTENTIAL INVESTORS FOR A DEAL TO BE OFFERED LATER.

 

YOU CANNOT DO A SEMINAR, OFFERING A PRIVATE PLACEMENT TO THE GENERAL PUBLIC, CURRENTLY AVAILABLE OR CONTEMPLATED.  THAT WOULD CONSTITUTE A GENERAL SOLICITATION, WITHOUT QUESTION.

 

IN MARCH, 2005, THE NASD, (NOW FINRA) THE ORGANIZATION THAT GOVERNS THE ACTION OF LICENSED SECURITIES REPRESENTATIVES AND WORKS UNDER THE AUSPICES OF THE SEC, ISSUED NOTICE OT MEMBERS 05-18, THAT DEALS WITH THE ISSUE OF SOLICITATION OF INVESTORS, SPECIFICALLY IN THE TENANT-IN COMMON INDUSTRY, AND GIVES PROMOTERS OF GROUP INVESTMENTS INSTRUCTION AS TO HOW TO ATTRACT INVESTORS WITHOUT VIOLATING THE RULES OF SOLICITATION IN PRIVATE PLACEMENTS.  THE NOTICE STATES:

 

     “MEMBERS HAVE REQUESTED GUIDANCE WITH REGARD TO TWO SPECIFIC METHODS OF SOLICITATION OR ADVERTISING.  IN THE FIRST SCENARIO, A REGISTERED REPRESENTATIVE WHO ALSO HOLDS A REAL ESTATE LICENSE SOLICITS POTENTIAL INVESTORS BY ADVERTISING A “REAL ESTATE” SEMINAR.  AT THE SEMINAR, INVESTORS ARE GIVEN A PRESENTATION OF TIC EXCHANGES AND ARE MADE AWARE THAT THE MEMBER OFFERS TIC INVESTMENTS TO ITS CUSTOMERS.

 

 

SINCE THE ADVERTISEMENT FOR THE SEMINAR WOULD BE A GENERAL SOLICITATION, AND SINCE THE REFERENCES TO THE TIC INVESTMENTS CURRENTLY BEING OFFERED BY MEMBERS WOULD BE DEEMED AN OFFER OF THOSE SECURITIES, THE MEMBERS ENGAGED IN SUCH OFFERINGS WOULD NOT BE ABLE TO RELY ON THE EXEMPTION FROM REGISTRATION FOR PRIVATE PLACEMENTS UNDER REGULATION D.

 

IN THE SECOND SCENARIO, MEMBERS PLACE ADVERTISEMENTS IN NEWSPAPERS AND MAGAZINES THAT INDICATE THAT THE MEMBER SELLS TIC INTERESTS, BUT THE ADVERTISEMENTS DO NOT IDENTIFY ANY PARTICULAR TIC INVESTMENT FOR SALE BY THE MEMBER.  SINCE THE ADVERTISEMENT ITSELF IS A GENERAL SOLICITATION, THE ISSUE FOR MEMBERS IS WHETHER THE ADVERTISEMENT INCLUDES AN OFFER OF SECURITIES.

 

IN GENERAL SUCH AN ADVERTISEMENT WOULD NOT BE DEEMED AN OFFER OF SECURITIES IF;

 

 

•   THE ADVERTISEMENT IS GENERIC

•   THE ADVERTISEMENT IS NOT BEING MADE IN CONTEMPLATION OF AN OFFERING; AND

•   THE BROKER-DEALER HAS PROCEDURES TO ENSURE THAT AN INVESTOR SOLICITED VIA THE ADVERTISEMENT WILL NOT BE OFFERED TIC’S THAT THE BROKER-DEALER IS CURRENTLY OFFERING OR CONTEMPLATING OFFERING AT THE TIME OF THE INITIAL CONTACT.

•   ADVERTISEMENTS THAT DO NOT MEET EACH OF THESE CONDITIONS ARE LIKELY TO BE DEEMED GENERAL SOLICITATIONS AND INCONSISTENT WITH THE CONDITIONS FOR PRIVATE PLACEMENTS CONDUCTED IN COMPLIANCE WITH REGULATION D.  MOREOVER, IN ADDITION TO MEETING THESE CONDITIONS, THE OTHER REQUIREMENTS UNDER REGULATION D ALSO MUST BE MET, INCLUDING ESTABLISHING AN ADEQUATE, SUBSTANTIVE, AND PRE-EXISTING RELATIONSHIP WITH THE POTENTIAL INVESTOR AND COMPLETING A SUITABILITY ANALYSIS PRIOR TO OFFERING TIC’S TO SUCH INVESTOR”

 

 

MOST REAL ESTATE AGENTS ARE USED TO MARKETING REAL ESTATE TO THE PUBLIC THROUGH VARIOUS MEANS OF ADVERTISING TO ATTRACT INVESTORS THAT ARE KNOWN TO THE AGENT.  IN SELLING INVESTORS DIRECT OWNERSHIP IN A PROPERTY, THERE ARE NO RESTRICTIONS AGAINST THIS TYPE OF ADVERTISING.  HOWEVER, WHEN SELLING OWNERSHIP IN A GROUP THROUGH WHAT MIGHT BE DETERMINED TO BE A SECURITY, THERE ARE RESTRICTIONS.

 

 IT APPEARS THAT, FOLLOWING THE ADVICE GIVEN IN THE NOTICE, A GENERIC ADVERTISEMENT OR SEMINAR TO ATTRACT INVESTORS WHO ARE NOT KNOWN TO THE AGENT WOULD BE ALLOWED IF THERE ARE NO DIRECT OFFERINGS OR SALES OF SECURITIES MADE THROUGH THE ADVERTISEMENT OR AT THE SEMINAR.

 

IF THE ADVERTISEMENT OR SEMINAR RESULTS IN THE AGENT MAKING CONTACT WITH A POTENTIAL INVESTOR, THE ADVICE IS THAT THE AGENT KEEP RECORDS TO MAKE SURE THE INVESTOR DOES NOT INVEST IN AN OFFERING THAT IS AVAILABLE AT THE TIME OR AN OFFERING IS BEING CONTEMPLATED AT THAT TIME.

 

SEMINARS OR OTHER GENERAL SOLICITATION TO THOSE WITH WHOM THERE IS NO SUBSTANTIVE PRE-EXISTING RELATIONSHIP MAY ONLY BE MADE WITH THE INTENTION OF BUILDING A POTENTIAL CLIENT BASE.

 

 

 

OFFERS AND SALES OF SECURITIES TO THOSE PROSPECTS IDENTIFIED THROUGH A GENERAL SOLICITATION MAY ONLY BE MADE

i)                 AFTER A SUBSTANTIVE PRE-EXISTING RELATIONSHIP HAS BEEN ESTABLISHED,

 ii)  OF A PRODUCT THAT BECAME AVAILABLE AT LEAST 45 DAYS AFTER THE ESTABLISHMENT OF THE RELATIONSHIP, AND iii) THAT WAS NOT CONTEMPLATED AT THE TIME OF THE ESTABLISHMENT OF THE RELATIONSHIP.

 

DISCUSSIONS THAT WOULD APPEAR TO BE GENERIC WOULD SEEM TO INCLUDE:

 

•   Discussions of the Internal Revenue Code

•   Reference material on real estate investing

•   LLC or TIC ownership concepts that do not mention an offering or sponsor.

 

 

THE ACT OF MAKING AN OFFER TO AN INVESTOR IS NOT A SOLICITATION PER SE, AND IN FEDERAL LAW, THERE ARE NO LIMITS AS TO THE NUMBER OF OFFERS MADE, ONLY TO THE NUMBER OF INVESTORS.  HOWEVER, MAKING AN OFFER AS A RESULT OF A SOLICITATION IS THE ACTION THAT IS REGULATED.

 

 IN SUMMARY, IN MARKETING PRIVATE PLACEMENTS TO ACCREDITED INVESTORS, ONLY, HERE ARE SOME SIMPLE GUIDELINES TO FOLLOW:

 

1.     DOCUMENT HOW AND WHEN YOUR PRE-EXISTING RELATIONSHIP WAS ESTABLISHED

2.     PAY NO KICKBACKS OR FINDERS FEES TO ANYONE NOT LICENSED.  ITS ILLEGAL!  FEES MAY NOT BE SPLIT WITH NON-REGISTERED PERSONS SUCH AS LAWYERS, ACCOUNTANTS OR REAL ESTATE BROKERS.

 

HAVING SAID THAT, MANY OF YOU ARE AWARE THAT THE NATIONAL ASSOC. OF REALTORS (NAR) AND THE SEC ARE CONTEMPLATING COMING TO AN AGREEMENT REGARDING TIC COMMISSIONS.  THE TIC EXEMPTION PROPOSES THAT UNDER CERTAIN CONDITIONS, REALTORS WOULD BE EXEMPT FROM THE FOLLOWING SECURITIES RULES:

     *  BANNING ADVERTISING TO THE PUBLIC

     *  LIMITING TIC OFFERINGS TO ONLY HIGH NET WORTH INDIVIDUALS

     *  PROHIBITING REAL ESTATE BROKERS FROM RECEIVING REFERRAL

        FEES FROM SECURITIES BROKER-DEALERS.

 

THE CONDITIONS UPON WHICH THE TIC EXEMPTION RELIES INCLUDE THE FOLLOWING AS PROPOSED:

 

•   THE INVESTOR SIGNS AN AGREEMENT ALLOWING THE REAL ESTATE BEOKER TO ADVISE HIM/HER ON TIC DEALS BEING SOLD AS SECURITIES

•   THE REALTOR CANNOT ADVERTISE TENANT IN COMMON INVESTMENTS

•   THE SECURITIES BROKER DEALER DETERMINES ELIGIBILITY OF THE INVESTOR

•   THE SELLER DISCLOSES AND PAYS THE BUYER’S BROKER A REFERRAL FEE

•   THE REALTOR MUST SHOW THE BUYER TRADITIONAL REAL ESTATE OPPORTUNITIES AS WELL AS TIC DEALS

•   THE REALTOR MUST ALSO BE FAMILIAR WITH COMMERCIAL REAL ESTATE INVESTMENTS

 

THE NAR TIC EXEMPTION (IF PASSED) EQUATES TO NEW POSSIBILITIES FOR REAL ESTATE BROKERS, WHO WILL NO LEGALLY BE ABLE TO SHOW THEIR ATTRACTIVE TIC DEALS AND BE COMPENSATED ACCORDINGLY.

 

 3.   FOLLOW THE PATRIOT ACT.

 

A.    BE SENSITIVE TO MONEY LAUNDERING.

B.    IDENTIFY EVERY INVESTOR WITH A DRIVER’S LICENSE OR PASSPORT.

C.   FOLLOW PROCEDURES FOR PRIVACY AND PRESERVING CONFIDENTIAL INFORMATION.

 4.     TAKE ONE EXTRA STEP AFTER THE INITIAL INTRODUCTION AND THE RECEIPT OF THE PRE-EXISTING SUITABILITY QUESTIONNAIRE.  CALL, WRITE OR E-MAIL THE PROSPECTIVE CLIENT TO CEMENT THAT SUBSTANTIVE PRE-EXISTING RELATIONSHIP.  THEN DISCUSS THE SPECIFIC INVESTMENT OPPORTUNITY AFTER 30 DAYS.

 5.     DOCUMENT THAT FINAL STEP WITH NOTATIONS TO FILE AS TO HOW THE INVESTMENT MEETS THE INVESTORS INVESTMENT OBJECTIVES AND RISK TOLERANCE ALONG WITH HIS PRIOR INVESTMENT EXPERIENCE.  NOTE THE  SIZE OF THE SPECIFIC INVESTMENT IN RELATION TO THE CLIENTS LIQUID NET WORTH TO AVOID UNDUE CONCENTRATION.

 

 

ANALYST'S CONFLICTS

 

 

 

    In the Wall Street Journal, March 1, 2005, it was reported that arbitrators in Florida ordered Merrill Lynch & Co. to pay $731,000 in compensatory damages and $300,000 in punitive damages to Gary Friedman, a medical-malpractice lawyer in Coral Gables, Fla. and his wife.  The award was predicated on Merrill's failure to disclose that its analysts had conflicts of interest in recommending stocks.

 

     An NASD panel ruled last month that Merrill analysts "were guilty of intentional misconduct" in using a rating system that overvalued stocks they were covering.  The case is one of the first in which an investor won punitive damages against a Wall street firm for conflicted stock research.  It also is significant because Mr. Friedman relied on Merrill analysts to buy or hold 39 stocks that weren't involved in a $1.5 billion research settlement that Merrill and other Wall Street companies made in 2003 and 2004, said the Freidman's lawyer Robert W. Pearce.  He said Merrill did investment-banking work for about two-thirds of the companies in his client's portfolio at Merrill.

 

    New York Attorney General Eliot Spitzer and other regulators charged the firms with recommending stocks that they privately disparaged in order to get investment-banking assignments from the companies.  The three-person NASD panel said it reviewed "clear and convincing evidence" of analyst misconduct.

 

     An SEC  alert titled "Analyzing Analyst Recommendations" issued by the SEC in June 2002, points out that "[W]hile analysts provide an important source of information in today's markets, investors should understand the potential conflicts of interest analysts might face.  Examples given by the SEC are analysts who work for firms that underwrite or own the securities of companies the analysts cover, or analysts who themselves own stocks in the companies they cover, either directly or indirectly, such as stock-purchase pools in which they and their colleagues participate.  They may have participated in "venture investing" where the analyst, the analyst's firm and the analyst's colleagues acquire a stake in a start-up company by obtaining discounted, pre-IPO shares.

 

     The SEC alert states: "[Many] analysts work in a world with built-in conflicts of interest and competing pressures ... [which] can create pressure on an analyst's independence and objectivity."  some of the pressures identified by the SEC are investment banking relationships, brokerage commissions, analyst compensation, and ownership interests in the company who is the subject of the research rating.

 

     Underwriting a company's securities offerings and providing other investment banking services can bring in more money for firms than from brokerage operations or research reports.  The SEC alert points out what an investment banking relationship may mean:  The analyst's firm may be underwriting the offering which means the firm has a substantial interest, both financial and with respect to its reputation, in assuring the offer is successful.  Upbeat research reports and positive recommendations published after the offering is completed may "support" new stock issued by a firm's investment banking clients.  Unfavorable reports may hurt the firm's efforts to nurture a lucrative, long term investment banking relationship because the reports may alienate a client or potential client and cause the company to look elsewhere for its investment banking services.  It is no secret that brokerage firms are in intense competition with each other for investment banking business.  Favorable reports and positive recommendations may induce the company to hire the firm to underwrite a securities offering where an unfavorable report makes it less likely the company will hire the firm as an underwriter to sell its stock.

 

     Positive-sounding reports can help the analyst's firm make money indirectly by generating more purchases and sales of covered securities which, in turn, result in additional brokerage commissions.  analyst compensation can put pressure on analysts to issue positive research reports and recommendations.  Until recently, most firms linked compensation and bonuses, directly or indirectly, to the number of investment banking deals the analyst landed or to the profitability of the firm's investment banking division.

 

     In June and July, 2001. Wharton finance professor Andrew Metrick told the House Committee on Financial Services Subcommittee on Capital Markets:  "Its not unreasonable to say that if these analyst's were truly independent we would not have had the bubble and crash that we did have."  Professor Metrick pointed out that "there were tons of companies that were going public without profits, while, historically, only biotech firms had done this".  Other academics and Wall Street observers pointed out that many analyst's continued to recommend internet stocks long after it was clear that the bubble had burst, leading investors who followed those buy recommendations to suffer deep losses.  Business Week Online (March 5, 2001 issue) reported that investors lost $3 trillion in the stock market between March 2000 and March 2001.

 

     Benjamin Mark Cole, author of the book "The Pied Pipers of Wall street - How Analyst's Sell You Down the River," provided the subcommittee with research studies showing that, in the early 1970's, brokerage commissions supplied 60% of industry revenues.  But commissions fell after the federal government deregulated them in 1975, and commissions today provide less than 16% of  brokerage firm revenues.  To replace this loss, the industry turned to investment banking.  In 1974, Cole pointed out "the U.S. securities industry underwrote $42 billion worth of stocks and bonds.  In 1999, the industry underwrote 2.24 trillion, more than 50 times the pre-1975 level."

 

     The subcommittee considered a 1999 research study by Kent Womack, finance professor at Dartmouth's Amos Tuck School of Business Administration, and Roni Michaely, a professor at Cornell University, titled "conflict of Interest and the Credibility of Underwriter Analyst Recommendations."   The Womack and Michaely study found analyst's to be more optimistic about stocks underwritten by their own firms than they were about stocks underwritten by others.  But those optimistic forecasts tended to be wrong:  in the 24 months following IPO's, stocks recommended by analysts associated with the underwriting firms trailed stocks recommended by non-underwriters by 15.5 percentage points.  The underwriting analysts did much better when they recommended stocks their firms had not underwritten.  Womack and Michaely also found that analysts' "buy" recommendations outnumbered "sell" recommendations about six to one early in the early 90's.  By 1999, the study reported that the ratio had soared to as much as 100 to 1.  They concluded that buy recommendations by analyst's from brokerage firms which had recently brought out offerings of the stock in question "do show significant evidence of bias and potential conflict of interest."

 

     Investars.com, a company that tracks analysts' stock-picking performance, performed a study that encompassed the period that included the dot-com meltdown.  The Investars study found that the investment-banking conflict can have devastating effects on investor returns.  In a look at 19 major investment banks from January 1, 1997 through June 12, 2001, the study found that a portfolio of stocks recommended by analysts whose firms had "IPO relations" lost 51% of its value.  At the same time, the stocks recommended by analyst's without IPO relations fell by only 1%.

 

     New York Attorney General Spitzer began a probe into possible analyst conflicts in early 2001.  Spitzer accused the major brokerage firms of using upbeat stock research and positive recommendations during the 1990's bull market to lure investment banking business to the detriment of the small investors who relied upon the tainted research.  A settlement agreement, announced in December, 2002, required 12 major brokerage and investment banking firms to pay multimillion-dollar fines totaling about $1.5 billion and separate their stock research from their investment business.  The firms neither admitted nor denied the Attorney General's charge that they had duped investors.

 

     Salomon Smith Barney's former star telecom analyst, Jack Grubman, hyped many of the telecom stocks, most notably maintaining "buy" ratings on AT&T, Global Crossing and WorldCom while the stock values dropped precipitously.  Grubman's and Salomon's conflicts of interest did not go entirely unnoticed by the Salomon retail sales force, with scathing comments like,

 

     -  "Grubman's analysis and recommendations to buy (1 Ranking) WCOM [Worldcom], GX [Global Crossing], Q [Quest] is/was careless";

 

     -  "His ridiculously bullish calls on WCOM and GX cost our clients a lot of money";

 

    -  "How can an analyst be so wrong and still keep his job?  RTHM [Rhythm NetConnections], WCOM, etc.etc.";

 

    -  "Downgrading a stock at $1/sh. is useless to us";

 

    -  "How many bombs do we tolerate before we totally lose credibility with clients?"

 

Source - SEC v. Grubman Complaint, at #27, and see also # 22 - 26.

 

Yet, Grubman and his boss at Salomon, Sandy Weill, did not care one whit for the retail customers whose accounts were devastated by their fraud.  In its civil complaint filed against Grubman April 8, 2003, the SEC quotes a January 2001 email in which he states,

 

     "I never much worry about review.  for example, this year I was rated last by retail (actually had a negative score) thanks to T [AT&T] and carnage in new names.  As the global head of research was haranguing me about this, I asked him if he thought Sandy [Weill] liked $300 million in trading commission and $400 million [only my direct credit not counting things like NTT [Nippon Telecom] or KPN [KPN Quest] our total telecom was over $600 million in banking revenues.  So, grin and bear it..." SEC v. Grubman Complaint at #28.

 

At about the same time, Grubman emailed another friend admitting that he had upgraded AT&T only to obtain Weill's help in getting his children into an exclusive pre-school.

 

     "You know everyone thinks I upgraded T [AT&T] to get lead for AWE [AT&T Wireless Tracker].  Nope.  I used Sandy to get my kids into 92nd St. Y pre-school (which is harder than Harvard) and Sandy needed [the AT&T's CEO's] vote on our board to nuke [John] Reed in showdown.  Once coast was clear for both of us (i.e. Sandy clear victor and my kids confirmed) I went back to my normal negative self on T. [AT&T's CEO] never knew that we both (Sandy and I) played him like a fiddle".  SEC v. Grubman Complaint at #99.  The next day, Grubman emailed the same friend to say, "I always viewed T [AT&T] as a business deal between me and Sandy." Id at #100.

 

Salomon's complicity in this conduct, among other things, resulted in the filing of a separate SEC complaint against Salomon itself.  These Salomon conflicts of interest resulted in investment decisions based on tainted research, damaging the firms retail clients, immeasurably.  Grubman's illegal and fraudulent conduct was so egregious that he has been banned for life from the securities industry and fired by Salomon.

 

Salomon 's research department, in effect, was little more than a marketing division for the firm's investment bankers.  Instead of placing the financial interests of their small retail clients in the fore, as they had a fiduciary duty to do, Salomon placed its investment banking profits and its relationships with its investment banking clients ahead of its retail clients.  Citigroup (SSB) paid approximately $400,000,000 to the U.S. Government in a settlement over its tainted research.

 

 

 

HOW IT HAPPENED

 

 

 

     To understand how the present day relationship between investment banking and equity research evolved, we must take a trip back in time.  We will examine the industry over two very specific periods.  The first period begins at the end of World War II (1945) and continues through the end of fixed commission rates (1975).  The second period stretches from 1975 to the end of the 1990's "Bull" market in early 2000.  Unfortunately, as investors now know with the benefit of perfect 20/20 hindsight, the tremendous stock market price gains of the 1990's were an unsustainable bubble that has since burst.  Measured against the market's all-time highs, through the end of 2002, the Dow Jones Industrials were down 32%, the S&P 500 had fallen 49% , while the NASDAQ Composite Index was down a staggering 74%.

 

     Over the 1945 - 1975 period, a symbiotic relationship developed among research, sales, and trading at the large U.S. brokerage firms.  The system essentially worked in the following way....Working in the brokerage firm's equity research department, "Sell" side analysts sought out the stocks of the very best companies in their respective industry area to recommend.  At most firms, each industry group (such as aerospace, automotive, construction, electrical equipment, retail, semiconductors, telecommunications, etc.) had its own analyst.  After conducting a thorough review and analysis of all the firm's in their particular area of expertise, the analyst wrote a detailed research report that recommended certain stocks for purchase.  The finished research report, which was distributed to clients (via mailing lists during this era), also explained the rationale behind the analysts recommendation, usually in considerable detail.  Once the research report on any given stock was published, the analyst basically had to market his/her research to three audiences.

 

     *     The first audience was the analyst's own internal institutional sales force.

 

     *     The second audience was the firms highest producing retail brokers (if the firm had a retail business).  At most firms with a retail client base, only a certain select number of the biggest  commission-producing brokers were allowed to directly call and /or otherwise directly interact with the equity research analyst.

 

     *     Third, the analyst marketed his or her research to counterpart "Buy" side institutional analysts and/or money managers at large financial institutions such as Fidelity, Allstate, Alliance Capital and Vanguard, among many others.

 

     It was only by building a positive track record of "correct" research calls over a period of time, that the analyst was able to build his or her professional reputation, and win the confidence of the audiences discussed above.  Normally, all three audiences were skeptical of any new analyst, and simply would not use any analyst that they did not know or were not comfortable with.  From the ongoing interplay among and between this three sided relationship of equity research, sales and trading, the brokerage firm would receive financial remuneration as the following sequence of events occurred.  the analyst would put out a "buy" recommendation on a certain stock, the institutional sales force and the firm's retail brokers would believe the veracity of the analyst's story, and would then attempt to sell this investment recommendation to their clients (either institutional or retail).  If institutional and/or retail sales were successful in selling this particular research recommendation, the brokerage firms' trading department would execute the trade(s).  The commissions generated from the trade(s) would pay the salaries of the analyst and the salesperson/broker, with any residual monies going to the brokerage firm as profit.  During this era, before the end of fixed commission rates, and under this business model, equity research was a "profit" center even after substantial five and six-digit analyst salaries were factored in.

 

     With the end of fixed commissions in 1975, the U.S. brokerage industry entered an entirely new era with increased levels of competition occurring between and among the various firms as they pursued new clients and new business opportunities.  It was over this 1975-2000 time frame that the following events took place:

 

     1.  In this much more competitive post 1975 world, commission rates charged to the brokerage client fell dramatically, in many cases falling to only pennies per share traded.  In this environment and under changed operating conditions, it was no longer possible for research and/or trading to directly earn a profit.

 

     2.  Thus, the equity research department went from being a "profit" center to being a "cost" center.  Moreover, it was because of these changed economic dynamics in the brokerage industry that the new equity research/investment banking relationship was born.

 

     3.  Despite dramatic market fluctuations in recent years, basic Initial Public Offering (IPO) investment banking fees have changed little, and remain at the 7% level where they have been for a number of years.  In other words, a $100 million IPO (which was generally viewed as a "small" deal) would generate about $7 million in gross fees for the lead underwriting firm, with the net gain usually being in the $4 to $5 million range, after expenses.  Working with investment banking, equity research could once again "pay the bills" while continuing to pay analysts large salaries.

 

     4.  In the new highly competitive economic environment that arose in the U.S. brokerage industry after the demise of fixed commissions, equity research analysts became much more involved in looking for, soliciting and supporting investment clients.  As a result of this relationship with investment banking, the average New York based equity research analyst could earn a six-digit salary, while analysts who were highly ranked in the Institutional Investor research poll could take home annual paychecks that stretched out to seven, and in some cases even eight digits.

 

     5.  To manage the inherent conflict between the underwriting of new securities (investment banking) and the publication of research about an existing company's future business prospects (equity research) the SEC promulgated rules and regulations that required a "Chinese Wall" to be established between the two functions.

 

     6.  Conceptually, the "Chinese Wall" was erected by the regulatory authorities to prevent the direct flow of information between investment bankers (whose access to information in discussions with company management often made them "insiders") and equity research, where information about any particular company was supposed to be independently gathered, compiled and analyzed.  In the early years after the end of the fixed commission era, the required "Chinese Wall" separation between investment banking and equity research was rigorously enforced.  However, as practiced by the U.S. brokerage industry in the 1990's (with the de facto consent of the SEC, which did little to enforce the "Chinese Wall" separation as originally envisioned), the separation between investment banking and equity research became less and less formal.

 

     The old adage of "follow the money" will highlight what has happened to brokerage firm equity research departments and equity research analysts since 1975.  During the fixed commission era, equity research analysts could absolutely focus on making the best "stock market" investment recommendations because that is how they built their professional reputations and got paid.  In those days, if an analyst recommended a certain stock, successfully sold it to all the necessary target audiences, and the price of that stock went up, the analyst was rewarded in two ways:

 

     *     First, the research analyst's professional reputation was enhanced, as he or she became perceived as an industry expert and a good stock-picker.

 

     *     Second, the analyst and the analyst's firm both got paid because the business of recommending stocks and trading stocks, particularly if the analyst's investment calls were timely and accurate, was quite profitable.

 

     In the brokerage industry environment of the late 1990's equity research and trading were no longer profitable in and of themselves, while investment banking remained highly profitable.  In this setting, the research analyst could potentially be faced with diverse situations that often resulted in very different outcomes:

 

     1.  In the first case, and in what would be an ideal situation for the equity research analyst, he or she would be able to recommend the stock of an investment banking client based on that company's strong business fundamentals.  Next, when that firm's sales, earnings and stock price all increased in line with stated forecasts, the analyst's professional reputation was enhanced.  In this situation, the investment banking client was happy, and the analyst and his/her firm both got paid through the investment banking side of the business.

 

     2.  However, the second situation we will examine is not nearly as positive.  What would happen if an investment banking client's fundamental business story was not good, and would not normally merit a positive investment recommendation?  Then, assume that the investment banking relationship with this particular firm remained highly profitable for the brokerage firm.  Would the research analyst write a negative, but honest, assessment based on the company's underlying business fundamentals, or would the analyst write a positive business review knowing that it simply was not true?

 

     3.   If there were no threats against the analyst's job security and/or income, most professional research analysts would write an accurate assessment of a high profile investment banking client's business outlook, even if it upset the management of the outside client firm.  However, if the analyst perceived that his or her job and/or income were at risk if the high profile investment banking client were offended, then many analysts would likely choose to be less than honest in their public commentary (either written or oral).

 

     4.  Simply put, the "conflict of interest" situation discussed above was quite prevalent in the U.S. brokerage industry of the late 1990's.  Unfortunately, it now appears that many analysts were looking more to their own perceived self-interest (keeping their high paying job), rather than clearly and honestly stating what they truly believed to be the fundamental business outlook for any given investment banking client.

 

     5.  In addition, given the increased focus on investment banking that was keyed by the high level of profit generated  by this activity in the 1990's, many industry research analysts began actively searching for private companies that could be taken public via an Initial Public Offering (IPO).  Often, these firms were small and not well known, and would give the research analyst an ownership stake as compensation for setting up the investment banking relationship.

 

     6.  If and when the IPO did occur, these analyst ownership positions usually became quite valuable.  However, if the analyst then uncovered "bad news" about a company in which he or she had an ownership stake, how likely were they to write a negative (but honest) report that would negatively impact their personal wealth?  Analysts having a "vested interest" in the companies that they covered and then write about it, is the second major "conflict of interest" that occurred during the bubble market of the late 1990's.

 

     This examination of the U.S. brokerage industry has highlighted how the equity research department moved from being a "profit" center during the fixed-commission era, to a "cost" center by the time the "Bull" market of the 1990's rolled around.  While this change in internal industry dynamics certainly can explain some of the increased pressure that was faced by the "Sell" side equity research analyst over the 1975 through 2000 period, it does not explain why brokerage firm legal and compliance departments allowed the "Chinese Wall" separation between equity research and investment banking to become meaningless.  In fact, as highlighted in a number of Wall Street Journal articles, at least one large brokerage firm had a number of equity research analysts report directly to senior investment bankers.  Neither, in  spite of structural dynamics, is there a satisfactory explanation for the reason that the U.S. brokerage industry was left to its own devices by regulators during the latter part of the 1990's.  Nor does the change in industry dynamics explain why senior management and/or senior investment bankers allowed highly inflated business forecasts to go unchallenged to the investing public as if these projections were derived through truly independent research.

 

     Did a number of large U.S. brokerage firms simply have their senior management and investment banking leadership positions filled by dishonest people, or was there some other dynamic at work here?  Between 1982 and 1992, the three large brokerage firms did not combine the efforts of different departments into a single-minded pursuit of new business opportunities.  In other words, a research analyst would initiate coverage on stocks he or she believed had the most upside price potential, without looking at the underlying company for commercial banking, investment banking, mergers/acquisitions, and/or other related new business opportunities.  After 1992, this began to change rapidly as a number of large brokerage firms merged with commercial banks, investment management companies, and insurance companies who were searching for distribution of "other" financial products.  Research analysts now began to get calls from senior persons in other departments of the firm who were looking to leverage the research relationship in an effort to win new business in both traditional and non-traditional areas.  If you were senior to the person calling with the request, you could readily say "no" if you did not like what was being proposed.  However, if the person calling was senior to you, then it became much more difficult to say "no".  In other words, the "separation of powers" that allowed research analysts a great deal of autonomy to pick and choose which stocks to cover and which not to cover began to be usurped, primarily by investment bankers, from the mid-1990's on.  Also frowned upon by investment bankers was the publication of any research report that expressed anything but the most glowing opinion about an investment banking client.

 

     During the 1990's, the traditional brokerage firm changed from a company primarily focused on client services (institutional and/or retail) into a "financial supermarket".  Once in the "financial supermarket" mode, brokerage firms were looking to offer clients a wide array of services ranging from traditional brokerage services like research and trading to commercial banking, investment banking, merger/acquisition advisory, and asset management, among others.  The concept of being a "team player" was widely heralded, with the expectation being that each person involved would bring all of their particular experience and expertise to bear, with the primary focus being to get a particular piece of business done.  What an individual research analyst thought about any particular business transaction was not important.  All that was important was that everyone totally supported the "team effort" and got the deal done.

 

     In retrospect, it is not surprising that the U.S. brokerage industry now labors under a cloud of scandal and controversy.  Particularly egregious examples of questionable industry behavior were the low-quality IPO deals that were brought public during the bubble market of the 1990's.  Under the new "team concept" once a decision had been made at the upper levels of management to pursue a particular business opportunity, everyone at the firm was expected to march in unquestioning lockstep until the transaction was completed.  Anyone who questioned a less than "top-flight" transaction was accused of not being a "team player".  Then, in a number of cases, analysts who persisted in attempting to write factual research reports or resisted supporting the "low grade" transactions that became common during the latter part of the 1990's were fired.  While all brokerage firm employees who supported these questionable business transactions must share in the blame for what happened, analysts are being particularly singled out because what they said about any particular stock or transaction was "on the record".  Obviously, a published research report can be dissected and examined word-by-word and sentence-by-sentence long after all other traces of a "deal gone bad" have long since vanished.

 

     On the other hand, in many instances, analysts deserve to be blamed for much of the shoddy research that occurred during the late 1990's.  It was analysts who thought up new and novel valuation measures like backlog to sales/book to bill ratios, times sales ratios, times operating cash flow ratios, times free cash flow ratios, and economic value added measures using unrealistic growth and discount rates when a company's stock price no longer appeared attractive using established measures like times earnings per share (the old P/E ratio).  It was also analysts who came up with even more bizarre valuation parameters like market share of an undefined or unprofitable market, mouse clicks (hits) per web site, and the number of incremental new subscribers per month regardless of customer cancellation rates and/or other true cash and profitability measures.

 

     Although there appears to be enough blame to go around, it is clear that the "team player" or "team concept" mode of doing business that was espoused by U.S. brokerage firms during the 1990's made it easy to silence critics and suppress dissent.  It became hard to individually oppose a large number of "team" members when the analyst did not have perfect information and foresight, particularly if billions of dollars were at stake, and if the market was taking the price of a security well above what the analyst believed was reasonable.  Keep in mind that no analyst could predict with 100% certainty what would happen to the price of any stock over any given period of time.  Finally, when the market price of a security went against an analyst's deeply held convictions and expectations in a major way for a prolonged period of time, that analyst would almost always be plagued by doubts.  He or she would keep asking, "What does the market know that I don't know?"  If this went on long enough, even the most convinced analyst might waver and change his or her investment opinion, because the belief was that the millions and millions of people whose combined input went into the making of any given stock's market price was collectively in possession of more information than the individual analyst.

 

     Placing blame after any negative occurrence has taken place, particularly if backed by major fines and/or prison time, will normally prevent the same thing from happening for some period of time going forward.  However, people forget over time, and the human emotions of fear and greed will once again lead to market excesses.  However, the blame for the extreme market excesses of the late 1990's should be placed primarily with senior management persons and brokerage firm legal and compliance departments along with those individual analysts who acted in a less than professional manner, and who essentially "sold their soul" to the highest bidder.  Keep in mind that senior management is responsible for all that happens or fails to happen at their firms.  During the decade of the 1990's, they established the culture that put profit and the "team player" concept of doing business above ethics, client service, and individual employee dissent.  It was senior management who rewarded "rogue" analysts and investment bankers with enormous seven and eight-digit salaries.  It was senior management who reined in their firm's legal and compliance departments, and who turned a blind eye to the excesses that occurred at their firms during the latter part of the 1990's.  It was even senior management, with the help of their compliance and legal departments, that convinced regulators, during inspections and audits, that the "Chinese Wall" was firmly standing and that there was no need to interfere with the raging "bull market", which at the time, seemed to be making everyone rich.

 

     Finally, individual investment bankers, analysts, traders, and brokers all have to look in the mirror and judge whether they honestly performed their jobs to the best of their ability.  Can they honestly say that they put their clients' interests ahead of their own.  Until the investing public perceives that client interests are once again paramount, we should not expect a major sustainable stock market recovery to occur.

 

Note:  Attorney Ken Wood contributed to this material and portions of an article by Peter L. Aseritis were included.

 

 

 

NETTING OUT THEORY

 

 

 

     Also known as the Total Return Theory, this method of reducing losses is often used by respondent's in arbitration cases.  To do otherwise, states respondent, and to just to consider losses in one of several accounts is tantamount to "cherrypicking".  Further, defense counsel often attempts to garner gains of long past years to offset losses in recent periods.  Remember the NASD has a six year eligibility rule and wouldn't respondent be the first one to cut off "losses" if they occurred more than six years prior to the filing of the statement of claim.

 

     There is another problem with this netting out theory.  Logically, it follows that claimant doesn't have to complain about an account that is handled suitably.  In other words, you don't give the broker or brokerage firm accolades or brownie points for doing what they were supposed to do.  They are expected to follow the rules and recommend suitable trades.  That is what a full service broker is paid to do.  Claimants in arbitration then have the right to isolate the unsuitable portion of an account relationship if significant, and deal with it separately.  This is especially true if that unsuitable portion is in excess of 10 - 15% of the total entire account relationship.  In other words, as Merrill Lynch properly states, in a moderate account, you would not be surprised to find 10% to 15% in speculative securities for complete portfolio diversification.

 

     There is well settled case law regarding the netting of an account's profits against losses.  In Kane v. Shearson, 916 F.2d 643, 646 (11th Cir. 1990), the appellate court affirmed the trial court's reversal of an arbitration decision that offset the claimant's losses by his gains from the same unsuitable stock.  The court concluded that "[t]here is no indication that other transactions are relevant to this calculation at all."  the Court further observed the perverse incentives of such a "netting" theory stating:  "[T]here is no support to be found under federal...law for the "netting " theory Shearson argues for here...As the district judge noted, "If the ...methodology espoused by [Shearson] were adopted, it could serve as a license for broker-dealers to defraud their customers with impunity up to the point where losses equaled prior gains."

 

    In Randall v. Loftsgarden, 106 S.CT.3143, 3153 (1986), the United States Supreme Court rejected a netting analysis based on the deterrent purpose of the securities laws: "This deterrent purpose is ill-served by too rigid insistence on limiting plaintiff's to recovery of their net economic loss."  In a case in the appellant circuit in California, Nesbit v. McNeil, 896 F.2d 380, 385, 386 (9th Cir,1990) the appeals court affirmed the trial court's rejection of the netting argument, stating that "there is no reason to find that [plaintiffs] should be denied a recovery because their portfolio increased in value, either because of or in spite of the activities of the defendants, "and that "gains in portfolio will not offset losses...."

 

     Again in Davis v. Merrill Lynch, 906 F.2d 1206, 1218 (8th Cir. 1990), the federal appeals court, interpreting both state common law and federal statutory claims, rejected the netting argument: We disagree with Merrill Lynch's argument that no actual damages were sustained....The implications of this argument are disturbing.  If we were to adopt Merrill Lynch's view. securities brokers would be free to churn their customers' accounts with impunithy so long as the net value of the account did not fall below the amount originally invested.  Finally, in Levine v. Futra, the court similarly rejected a "netting" defense, stating that "this court holds that plaintiffs suffered damages even though the investment portfolios incurred a net gain."  In short, no netting may occur.  Respondent's misconduct cannot be rewarded or mitigated by the mere fortuity that prior transactions may have been profitable.

 

     The above analysis carries significant weight when the total account relationship while at the subject broker dealer, substantially under-performed the market.  Further, one account or securities position, in relation to the total account relationship, may be so egregiously unsuitable, it may rise to the level of rescission as the proper measure of damages.

 

 

THE SUB-PRIME CRISIS

 

 

TIME LINE

 

 

 

March 1, 2006 - Sub-prime meltdown begins

 

May 3, 2006 - Ameriquest Mortgage Co. closes 229 offices and lays off 3,800 employees

 

June 14, 2007 - U.S. Mortgages enter foreclosures at a record pace

 

October 1, 2007 - All time record high on the Dow Jones Industrial Average

 

January 11, 2008 - Countrywide Financial collapses

 

February 14, 2008 - Auction Rate Securities market fails - $300 billion in assets frozen

 

March 17, 2008 - Bear Stearns, a major Wall Street firm collapses.  Share prices at $30 on March 14, drop to $2 on March 17.

 

July 11, 2008 - IndyMac Bank collapses

 

July 23, 2008 - "Death spirals" for Citigroup, Merrill Lynch, Washington Mutual, etc.

 

September 8, 2008 - U.S. Government seizes Fannie Mae and Freddie Mac

 

September15, 2008 - Merrill Lynch avoids total collapse with Bank of America takeover

 

September 15, 2008 - Lehman Brothers files biggest bankruptcy in U.S. history; Record $613 billion of debt

 

September 16, 2008 - Insurance giant AIG avoids collapse with emergency bailout of $85 million

 

September 26, 2008 - Washington Mutual seized by U.S. Gov't.; Biggest bank failure in U.S. history

 

September 29, 2008 - Dow Jones plummets a record 777 points as bailout plan rejected by House

 

October 7, 2008 - Dow drops 508 points

 

October 22, 2008 - Dow drops 608 points

 

November 5, 2008 - Dow drops 477 points

 

November 6, 2008 - Dow drops 438 points

 

November 12, 2008 - Dow drops 401 points

 

November 19, 2008 - Dow drops 423 points

 

November 20, Dow drops 443 points

 

 

 

Concerns about the financial stability of Fannie Mae and Freddie Mac have sent shares of the two companies plummeting by around 75 percent in the 2008. Now many investors are wondering if the companies may need a bailout by the federal government—a move many industry analysts say would be disastrous for the world’s financial markets. So, how did we get here?

 

The early days of Fannie and Freddie

 

The Federal National Mortgage Association (FNMA) and the Federal Home Mortgage Corporation (FHMC), usually referred to as Fannie Mae and Freddie Mac, make and guarantee home loans.

 

Fannie Mae was founded in 1938. In the wake of the Great Depression, the housing market collapsed and private lenders were wary of making home loans. Franklin Delano Roosevelt’s New Deal designed Fannie Mae to save the mortgage market by providing local banks with money to finance home loans.

 

In its early days, Fannie Mae operated much like a national savings and loan. In 1968, President Lyndon B. Johnson privatized the company in order to remove it from the national budget, a move that was most likely the result of fiscal pressures created by the Vietnam War.

 

At that point, Fannie Mae began operating as a government-sponsored enterprise (GSE), a private company owned by shareholders and listed on a stock exchange, but at the same time financially protected by the federal government.

 

In 1970, to prevent it from becoming a monopoly, the federal government created another GSE, Freddie Mac.

 

Today, Fannie Mae and Freddie Mac buy home loans from lenders, then hold them in their portfolios or repackage them into bonds called mortgage-backed securities.

 

Fannie Mae and Freddie Mac make money, primarily, by charging fees on the loans they repackage into mortgage-backed securities. Purchasers of these securities pay these fees in exchange for a number of risks that Fannie Mae and Freddie Mac take by buying the home loans. Perhaps the greatest one is credit risk, the possibility that the borrowers of the underlying loans will default. In essence, Fannie Mae and Freddie Mac guarantee that the principal and interest on loans underlying their mortgage-backed securities will be paid—even if the borrower defaults.

 

As GSEs, Fannie Mae and Freddie Mac have a myriad of government protections, perhaps the most notable of which are access to a line of credit through the U.S. Department of Treasury and exemption from Securities and Exchange Commission (SEC) oversight.

 

A problematic history

 

Throughout the years, the companies’ exemption from SEC oversight has been of great concern to many investors due to the significant role Fannie Mae and Freddie Mac play in the nation’s—and even the world’s—economy.

 

Fannie Mae and Freddie Mac are the nation’s largest buyers of home loans. Together, they own or guarantee about $5 trillion of mortgages, close to half the mortgage market. Because they promise to step in and make good on their loans if the homeowners default, the companies guarantee trillions of dollars worth of loans, making them major players in the nation’s housing market.

 

At the same time, the companies’ status as GSEs—and their exemption from SEC oversight—means that they are not required to report to the public any financial difficulties that they may have. They are the only two Fortune 500 companies with such a privilege.

 

Together, those two factors worry many investors, because if one of the companies should experience difficulty—or worse yet, collapse—it’s possible that no one would know until it was too late. That could be disastrous for their shareholders, for obvious reasons—but also for the entire credit market. The U.S. government does not explicitly back Fannie Mae and Freddie Mac and the mortgage-backed securities they issue. Any possibility of their failure would likely lead to a meltdown in the world credit markets; if their guarantee is deemed worthless, millions of people worldwide who hold their mortgage-backed securities would panic, try to sell, and ultimately lose money.

 

As a result, the investment community generally agrees that the federal government will not allow the collapse of Fannie Mae and Freddie Mac. Moreover, if the federal government takes over the companies, U.S. taxpayers could be on the hook for hundreds of billions of dollars.

 

While these fears may seem extreme, they are not completely unjustified, as the companies have been plagued by scandal throughout their history. For example, in 2003, Freddie Mac revealed that it had understated its earnings by almost $5 billion—and was fined $125 million. And in 2004, Fannie Mae was investigated for widespread problems in its accounting practices, including shifting losses so its senior executives could earn generous bonuses.

 

Recently, worries about Fannie Mae and Freddie Mac have increased due to the state of the housing market. Before we explain why, let’s look at the history of the sub-prime crisis.

 

From 1998 though 2005, nationwide housing prices rose at an average annual rate of around 7.25 percent or 10 percent, according to the two most widely cited measures of housing prices, the Office of Federal Housing Enterprise Oversight (OFHEO) Index and the S&P/Case-Shiller (S&P/CS) Index. Even more dramatic numbers were seen during the last two years of the housing market boom, 2004 and 2005, when the OFHEO Index rose 9 percent per year and the S&P/CS Index rose more than 13.5 percent per year.

 

As a result, from 2004 to 2006, everyone wanted to get in on the action, including borrowers who could not qualify for traditional mortgages. These borrowers were everywhere, of course, but the most notable concentration was in the Sunbelt states and the upper Midwest. The Sunbelt states—Arizona, California, Florida, Nevada, and Texas—had booming real estate markets, and non-traditional mortgages helped borrowers afford larger homes by offering lower payments. In the upper Midwest states—Illinois, Indiana, Michigan and Ohio—housing prices were not rising significantly; however, deteriorating labor market conditions (such as in the automotive industry) created a number of borrowers who could not qualify for traditional mortgages.

 

In response to this demand, lenders made credit available to these borrowers. Rather than getting traditional mortgages, borrowers took out sub-prime mortgages, given to those with questionable credit histories—and Alt-A mortgages, to those without documented income. These mortgages also had a number of features designed to keep monthly payments low. For example, the commonly used 2/28 adjustable rate mortgage (ARM) had an initial interest rate set for the first two years and a floating interest rate thereafter. There were also interest-only mortgages, negative-amortization mortgages, and—something that may seem bizarre as we look back—option mortgages, which allowed the borrower to decide how much he or she wanted to pay each month.

 

Lenders and companies, Fannie Mae and Freddie Mac among them, took these sub-prime mortgages, and, as they did with all mortgages, created mortgage-backed securities. Sometimes, those securities had different “tranche's", each with different streams of income. For example, the first tranche’s income stream might be relatively secure, the second tranche’s income stream less so, and third tranche’s income stream even less so. Moreover, losses were allocated from the bottom up.

 

With this kind of structure, companies that repackaged mortgage-backed securities were able to obtain investment-grade ratings on billions of dollars of securities that had relative unsecured credit—that is, those sub-prime mortgages—as underlying collateral.

 

Now a whole new market for mortgage-backed securities opened—namely, to those with no expertise in evaluating the underlying collateral of mortgage-backed securities, who invested—based solely on the securities’ ratings.

 

That brought even more demand for sub-prime mortgages; it became a vicious circle as it grew from $35 billion in 1994 to $140 billion in 2000, an average annual growth rate of 26 percent, according to the Federal Reserve Bank. Similarly, sub-prime loans as a share of total mortgage originations grew from 5 percent in 1994 to 13.4 percent in 2000.

 

This process continued through 2005. Everything fell apart in 2006, as two economic situations combined to create what many industry insiders say was the perfect storm: interest rates began to rise, and housing prices began to weaken.

 

First, let’s look at interest rates. As noted above, a 2/28 ARM is originated with a low initial interest rate. After two years, the interest rates reset to a level based on the then-current six-month London Interbank Offered Rate (LIBOR) plus a margin. It resets at least annually thereafter. As an example of how this affected sub-prime borrowers, take the typical interest rate on a 2/28 ARM in early 2005, which was around 5 percent. At that time, ARMs taken out by sub-prime borrowers typically reset to LIBOR, plus about 6 percent. With LIBOR about 5 percent, loans charging 5 percent interest quickly jumped to 11 percent. A homeowner with a $200,000 mortgage would see monthly payments jump from around $1,200 to more than $2,000.

 

We all know what borrowers who cannot make their mortgage payment do: They refinance or sell their home. This time, though, they couldn’t refinance because interest rates were rising—and they couldn’t sell because the housing market was plummeting. In 2007, sales of existing single-family homes fell by 13 percent, the largest amount in 25 years, according to the National Association of Realtors. Moreover, the median home price dropped 1.8 percent to $217,000 for the entire year—the first annual price decline on record, which goes back to 1968. Lawrence Yuan, the chief economist at the National Association of Realtors, called this decline unlike any seen since the Great Depression.

 

Borrowers who could not make their mortgage payments had only one choice, so delinquencies and foreclosures on sub-prime loans started to rise. In the first quarter of 2006, the seasonally adjusted delinquency rate for sub-prime loans was 11.50 percent, according to the Mortgage Bankers Association. In the first quarter of 2008, it had risen to 18.79 percent. At that time, sub-prime ARMs represented 6 percent of U.S. loans outstanding and comprised 39 percent of foreclosures started.

 

Where are we now?

 

When the sub-prime meltdown first began, many economists thought it would be contained to 2007. But the crisis continues to unfold.

 

First, it does not appear that lenders—despite their claims to the contrary—rediscovered credit quality after the sub-prime woes first surfaced. Sub-prime loans that originated in 2007 are defaulting at even faster rates than those originated in 2005 and 2006, according to Moody’s. Seven percent of 2007 sub-prime loans defaulted within the first three months of origination, compared to just 4 percent of 2006 sub-prime loans.

 

Moreover, we are at the time of year when many ARMs reset. The value of sub-prime loans resetting to higher interest rates has been estimated be $500 billion in 2008, up from $400 billion in 2007. If that is indeed true, we are likely to see continued high default and foreclosure rates through 2008 and into 2009.

 

To support that projection, foreclosure filings grew by 53 percent year-over-year in June, according to RealtyTrac, which monitors default notices, auction sale notices, and bank repossessions. Nationwide, 252,363 homes received at least one foreclosure-related notice in June—one in every 501 U.S. households. Lenders repossessed more than 71,000 properties. The problem was nationwide, as foreclosure filings increased year-over-year in all but 11 states. Nevada, California, Arizona, Florida, and Michigan continued to have the highest foreclosure rates. In Nevada, one in every 122 households received a foreclosure-related notice in June, more than four times the national rate.

 

What does it mean for our old friends Fannie and Freddie?

 

As the credit markets have dried up, Fannie Mae and Freddie Mac have played an essential role in the country’s mortgage market. They have been the lenders of last resort, providing much-needed liquidity to the housing markets. As a result, banks and other lenders were able to make loans they otherwise wouldn’t have been able to make, and make them at lower rates.

 

Now that homeowners are defaulting and going through foreclosure at alarming rates, Fannie Mae and Freddie Mac are being forced to make good on their guarantees. Since last July, they’ve reportedly posted combined losses of close to $13 billion. And investors are worried there are more losses ahead.

 

Worries about the companies’ sub-prime exposure have led their stocks to decline for months, but the panic hit a crescendo in mid-July when a report from a Lehman Brothers analyst warned that a proposed accounting rule change would require the two companies to keep significantly more capital on hand. The Financial Accounting Standards Board is reviewing a rule that might force financial firms to move mortgage-backed securities currently off their balance sheets to their balance sheets. If Fannie Mae and Freddie Mac have to do this, Fannie Mae would have to add $46 billion to its reserves, the report said, and Freddie Mac would have to add $29 billion. In today’s tight credit market, that kind of cash would be hard to raise. Indeed, the chief economist for Moody’s Economy.com, Mark Zandi, has said that the companies may need to issue more stock to raise money, thus diluting the value of existing shares.

 

In fact, Freddie Mac is considering raising as much as $10 billion by issuing more stock to the public.

 

Adding insult to injury, not long after the Lehman Brothers report came out, a former Federal Reserve governor said he believes Fannie Mae and Freddie Mac are already insolvent and urged the federal government to take them over. Granted, that governor has long been critical of Fannie Mae and Freddie Mac, but it was a serious statement; if the government takes over the companies, shareholders would likely get nothing—and U.S. taxpayers would be on the hook for all the companies’ debt.

 

The sell-off began then. Immediately after the markets opened on July 11, shares of Fannie Mae and Freddie Mac fell more than 47 percent from their already battered closing prices the day before. Although they made up much of their losses, Fannie Mae finished the day down 22 percent and Freddie Mac was down 3 percent. Both companies’ stocks were down around 45 percent for the week—and 75 percent for the year.

 

As evidence of their importance to the U.S. economy as a whole, the problems at Fannie Mae and Freddie Mac also weighed on the broader markets, at one point forcing the Dow Jones Industrial Average down below the 11,000 mark for the first time in nearly two years.

 

Is a government bailout likely?

 

The question is, are the companies really in trouble or is the sell-off just the result of a temporary panic?

 

The Office of Federal Housing Enterprise Oversight (OFHEO) has reported that the two companies were “adequately capitalized,” meaning they have enough cash on hand to stay in business. And some people agree that the companies are doing just fine. For example, in a July research note, a Keefe, Bruyette & Woods analyst wrote that the OFHEO, the primary federal regulator for Fannie Mae and Freddie Mac, already requires reserves for off-balance sheet securitizations and due to those requirements, in part, the pair would not be affected by the new accounting standards. Even Senator Christopher Dodd, the chairman of the Senate Banking Committee, has defended the strength of the two companies.

 

Perhaps the bigger question on investors’ minds is, “If the companies are indeed in trouble, will the federal government step in and save them?”

 

As noted above, the law that created Fannie Mae and Freddie Mac explicitly says the government does not guarantee the loans. However, there is a widespread belief that Fannie Mae and Freddie Mac are backed by some sort of implied federal guarantee. Vernon L. Smith, 2002 Nobel Laureate in economics, has even created a new name for such an arrangement, calling Fannie Mae and Freddie Mac “implicitly taxpayer-backed agencies.” As a result, a majority of investors believe that Fannie Mae and Freddie Mac are simply too important to the economy for the federal government to let them fail, and policymakers would step in to prevent a default.

 

That seems to be the case. Although a full-scale bailout has not been discussed, on July 13, the U.S. Department of the Treasury and the Federal Reserve announced a plan to support Fannie Mae and Freddie Mac should it become necessary. Treasury Secretary Henry Paulson said the Bush administration will ask Congress to enact legislation to increase temporarily the companies’ lines of credit with the Treasury and also allow the Treasury to buy stock in the companies. In addition, the Federal Reserve said it will give Fannie Mae and Freddie Mac the same access to Federal Reserve Bank of New York funds as commercial banks and Wall Street firms.

 

“They play an important and vital role in our economy and housing markets today, and they need to continue to play an important role in the future,” Paulson told legislators, in an effort to calm investor anxiety.

 

However, for every position, there is an opposing position. Many people say the federal government should allow Fannie Mae and Freddie Mac to falter. After all, their poor mortgage lending practices helped put us in the sub-prime crisis—and many think that there is no crisis that cannot be made worse by government intervention. By stepping in to save Fannie Mae and Freddie Mac, it can be argued, the government will put us in an even bigger financial muddle.

 

Where do we go from here?

 

Investors recently panicked about the financial sector after a government takeover of IndyMac in mid-July, and widespread uncertainty about Fannie and Freddie’s future.

 

But as the time progressed, investors got some relief from a big decline in oil prices (down about 11% in one week), and a stronger-than-expected earnings announcement and 10% dividend increase from Wells Fargo. The San Francisco-based bank’s results, which were down year/year (but not as much as feared), triggered a big relief rally in the financial sector. JPMorgan and Citigroup’s better-than-expected quarterly results kept the momentum going, despite a much weaker than expected announcement from Merrill Lynch.

 

Merrill Lynch’s $9.75 billion write-down ($3.75 billion more than expected) and $4.97 billion quarterly loss probably would have had a much bigger impact on the market had it not been for a rule enforced by the SEC that prevents shorting in Fannie Mae, Freddie Mac, and 17 other financial institutions (one of them being Merrill).

 

The rule caused a lot of short positions to cover in the financial sector and therefore provided additional buying pressure underneath the already-rallying group. As a result, the sector had an enormous bounce off oversold levels.

 

Does this mean it’s safe to go back into financials? No, because there will likely be several bank failures ahead since the government cannot save everyone, and many banks sold disproportionate amounts of sub-prime mortgages.

 

This is also not the time to go bottom fishing in other beaten down sectors. Let’s not forget that we have a stagflation environment on our hands (stagnant economic growth and high inflation).

 

       The year 2007 will not be remembered as the year of the credit crunch but reformation of the credit markets. The credit crunch was an inevitable reaction only exacerbated by the low interest environment not caused by it.

 

Over the last decade exchanges have been consolidating and squeezing the margins of investment banks.  Technology has demolished barriers to entry into the execution business further eroding the revenue of these traditional financial firms.  It used to be that brokers would make ½ a point on trades, taking the spread.  That spread has narrowed to pennies and will soon become a loss leader.

As the exchanges and brokerage/banker firms have become public the cyclic nature of there earnings have become exposed.  The NYSE and Nasdaq experience grater trading volume and listings in good times.  In bad times they may even lose money.  Banking houses also have a cyclic nature.  When times are good they make fortunes in IPO and Debt underwriting as well as M&A activity.  However when times go bad there are less deals to go around.

The investment banking firms want to continue to make money in good or bad times so they have branched into merchant banking and proprietary trading, simply swapping risk for return under the guise of doing it smarter then others.  When you buy an investment bank now, you buy their positions, their bets, every bit as much as their ability to underwrite.

Another ramification of eroding margins in their traditional business and constant quarterly pressure to improve the bottom line, was to create novel financial products to sell.  This is another way of slicing and dicing risk, creating a new market.  Where did their creative energies turn?  To the market 10x larger then the stock market, the debt market.  They created CDOs and CLOs among other others which created this new market and new commissions.

 

 

As with any financial transaction parties swap risk for return.  What turned these products into the harbinger of market change was that they exposed gigantic flaws in two financial systems.  These flaws are what the year 2007 will be remembered for.

These flaws coalesced into a storm then simultaneously shook the credit markets creating not an evaporation of capital but fostered an unwillingness to lend and an unwillingness to purchase debt created and packaged by others. Why? The shockwave of a real-estate correction not only showed the incomprehensibleness of the underling debt financing thus inherent illiquid but the rating agencies themselves did not property understand them and falsely attributed better credit standards then they deserved.  In their financial models they did not take into account the qualitative events incumbent in the debt such as zero income documented loans, the moral hazard of unscrupulous lenders, fraud and betting that universally, real-estate will never correct.

To compound the hits to integrity the rating agencies took was the fact that they were slow to react, downgrading 100's of CDOs at a time far after it was apparent to the street that there was problems.  Never before have entire tranches and sectors of debt been so mislabeled.  There are always problems in any human system, bond and corporate ratings will always have mistakes here and there but never before have so many been burned.

 

Bond insurance

 

The second problem spawned was a circular loop. The rating agencies own corruption of understanding is traced as the culprit.  The bond insurance faithfully using quantitative models of risk rates provided by the rating agencies were fooled.  They assumed they were insuring products of low order of magnitudes risk.  They were wrong.  Unknowingly, they were taking on massive amounts of risk. Also, the rating agencies that thought they were taking on low amounts of risk of liability, thus keeping the insurer’s rating high.  The same people who rate the products were rating the consumer.  If there is an impurity in the food there will be an impurity in the body.  Since the rating agencies were unable to see the original corruption, they were unable to see it in the whole.

 

Managers of debt purchased exotic and non exotic debt products and bought insurance to balance their risk.  The constriction of credit this year has been from the constant rehashing of the intrinsic level of risk in debt and the organic effect of the self fulfilling prophecies those actions create on a large scale.

 

 

 

The credit crisis has now claimed scores of victims. Lending institutions are unsure about lending to each other, zapping liquidity.  Every rating from rating institutions is now subject to second guessing in all areas from bond to corporate ratings. Investors now fear their financial institutions have made other complicated derivatives and swaps.  This fear of lending and buying securitized loans is responsible for a definite slowing in the economy, hence the fall in the equities market.

The last shoe has dropped with the discovery of near insolvency of the debt insurers finally brought the final miss-pricing of risk into the sunshine.  The investment banks have come clean and taken their major write downs and secured additional capital to sure up their balance sheets.  Money managers now know that their bond insurance may be worthless and have adjusted their portfolios accordingly. The FED has cut rates. On the bright side this shows the resiliency and efficiency of the free market place; despite catastrophic failure may only have a slowdown and correction, not a full blown recession

Already credit spreads are widening forecasting a return to lending.  Many now see a recession as a direct response to the lending crisis.  We will see over the coming weeks if they are right.

 

Lessons

 

 

After the tech bust investment bank’s analysts lost their reputation, if they ever had any, for fair analysis of the companies they covered.  Banks would make millions in fees as their analyst pumped up the company’s prospects.  Now there is a ‘Chinese-Wall’ erected between public analysis and the profit silos of the banking.  In reality no one believes that.

After the credit crash with their reputations in shambles rating agencies will now see greater competition from buy side research and private firms.  Currently companies pay for the privilege of being rated by such firms as S&P and Moody’s.  For example MCO Moody’s stock has dropped 50% in the last 12 months.  The authorities of research on the sell side has irrevocable shattered just as investment banks.  Managers will be hard pressed to blindly trust S&P, Moody’s or Fitch again.   Will a risk manager be able to blindly trust that a rated bond is truly AAA rated because a sell side company says so?

So a revolution has begun.  Look for paid for research on the buy side to start to take off on debt.  Also managers will be more hesitant to take on securitized debt.  They will look to invest in direct lenders or make the loans themselves no longer trusting 3rd parties.  The market will come back and be stronger as people have more confidence in debt self written.

Finally, look for investment banks to go after the largest market of all, the foreign exchange market.  Who knows how they will monetize the trading but it is the final frontier of profit being it’s daily trading volume is over 100x the US stock market.

 

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