More On Legal & Compliancefrom The Advisor's Professional Library
- The New and Improved Form ADV Whether an RIA is describing its investment strategy in advertisements or in the new Form ADV Part 2, it is important the firm articulates material risks faced by advisory clients and avoids language that might be construed as a guarantee.
- The Custody Rule and its Ramifications When an RIA takes custody of a clients funds or securities, risk to that individual increases dramatically. Rule 206(4)-2 under the Investment Advisers Act (better known as the Custody Rule), was passed to protect clients from unscrupulous investors.
More than four years after the financial crisis began, could it all happen again? Has Wall Street changed its ways? How about Washington? Yes, it can happen again, and no, there has been no meaningful reform.
The subprime crisis gave Wall Street a black eye. The public was astonished to learn that what it regarded as reputable firms were selling exotic securities that went by names such as collateralized debt obligations.
Financial executives at the time said with a straight face that that they were following best practices in risk management through “securitization,” which means bundling bonds with different risk characteristics. This would normally be true, except that the bonds mostly exhibited the same risk status, i.e. junk. That’s how they came to be called “toxic.”
Wall Street knew it was selling junk, and so bears responsibility for the crisis through which the country is still suffering. If these big CDO-selling firms were held to strict account, they would not exist today because they would have been forced to buy back their defective products deceptively sold. But today the nation’s five biggest banks are significantly larger than they were in 2007, with assets equal to 56% of the nation’s GDP compared with 43% of U.S. output back when “too big to fail” became a household idiom.
Then there is the Federal Reserve, one of whose jobs is to supervise banks and bank holding companies. But despite its failure to keep its banking charges from assuming too much risk, the Federal Reserve today has expanded supervisory authority extending to insurance companies and investment firms—through the Financial Stability Oversight Council established by Dodd-Frank. But the Fed’s most significant contribution to the financial crisis was in fueling a credit binge by keeping interest rates so low for so long, not noticing the asset bubbles it was creating.
And that brings us to the retail level. The lucrative CDO business were bundles that held junk, but that junk came from homeowners who bought houses they could not afford. Everything would have continued fine and dandy if asset prices continued to rise forever, which of course is impossible. Some homeowners behaved recklessly but many truly lacked the sophistication needed for an objective understanding of their financial limitatins. The banks and mortgage brokers, however, knew these were unqualified buyers, as their inside jokes about liar loans and Ninja loans (no income, no job or assets) attest.
The case of the strawberry picker in California’s Central Valley who bought a luxury $750,000 home on his $14,000 salary was an example whose extreme absurdity illustrates some of what was really happening in the housing bubble. Mortgage brokers, real estate agents and homeowners were all making lots of money fairly easily (as were their Wall Street counterparts with their huge bonuses). Why sell a $75,000 home and make just a $4,500 commission, when you can make $45,000 on a $750,000 estate? Ditto for loan brokers and the homeowners who flipped their homes.
And let’s not forget Washington’s role in all this. Pushing its weight through Fannie Mae and Freddie Mac, Washington pushed the mortgage industry to make loans to financially unqualified people. This affirmative action lending, like its college admissions counterpart, makes administrators and government types feel like they’ve accomplished something, but actually makes it harder for the intended beneficiaries through high defaults or low graduation rates, as the case may be.
Despite their being placed in government conservatorship in 2008, today Fannie and Freddie have an even larger footprint in the mortgage market than at the time of the crisis.
Looking back, a few points should be clear. First, nearly all the key institutions which caused the crisis remain in their positions, only with greater power than before: the government, which has ballooned in size, the Federal Reserve and Wall Street’s largest banks.
The mortgage brokers and real estate industry took a big hit, naturally, after the housing bubble popped, but the Fed is doing everything possible to nurse them back to strength with the lure of historically low interest rates. The pitch to consumers is that they should buy housing because financing terms are favorable, even though the underlying assets—i.e., housing—remain unhealthy.
The only key player who does not remain on top is the average American, whose median family net worth has fallen 39% —to 1992 levels—according to newly released Fed data (for the years 2007-2010; if the data extended to today, the drop in net worth would be far higher since property values have continued to sink).
Another key takeaway is that we did not see anyone go to jail in this crisis, and for good reason: None of this was illegal. Most people involved did not think they did anything wrong: They were just trying to make as much money as they possibly could.
And therein lies the danger for America nearly five years after the financial crisis. Our nation’s financial bankruptcy was preceded by our moral bankruptcy. And little has changed. To be effective over the long term, our laws must be based on a moral framework that outlaws conflicted advice, deception and fraud.
It is not enough to offer business-based arguments such as that offered by the financial industry in opposition to the SEC’s proposed reform of money-market funds. A floating NAV will be bad for business, but should taxpayers underwrite the risk of money funds or should asset managers who profit from the funds do so?
Closer to home, financial advisors must think long and hard about the moral hazards of not adhering to a fiduciary standard. Non-fiduciaries keep all their business options on the table, including putting their own interests before those of their clients. As with mortgage brokers, the ability to jack up earnings is ever-present, and thus the temptation to so as well.
Until we rebuild an ethical framework, from the bottom up, we will not emerge from a financial crisis until there is a match between what is good for society and what is legally permissable for people in business. Just as one's physical health is not optimized by consuming all the junk food a person can access, there is no way to achieve what is socially good without individuals, voluntarily and through appropriate regulation, denying themselves some of what they may want.