Caveat Emptor: Going To Banks For Financial Advice

I have a small concern with the drive to restructure investment banks, intended to eliminate conflicts of interest. It isn't that I think that's a necessarily bad thing for governments to mandate, or that there haven't been serious and outrageous breaches in the banks' Chinese walls between the sell and buy sides of their businesses. For individual investors, sure, they need protection. But professionals? Do they need protection?

Individual investors since they can be badly outgunned and misled when they are sold investment products that are bad for them (or anyone!). This is especially true when the true value of the assets has been buried or stained with fictional ratings. This is something that has occurred far too often, and not just with multiply-repackaged and insured mortgage backed securities, which makes credible the need to protect these investors. Even rich individual investors are often no better than "Mom and Pop" in sifting through the nonsense they are presented with by a smooth and engagingly friendly investment representative of a large and supposedly-venerable institution. Rich does not mean astute in this area as they have often achieved won their wealth in businesses far removed from Wall Street and Bay Street.

I am still astounded that even now so many people I know don't understand that garden variety mutual funds they are sold by their banks have a sales and management structure that favours the bank's bottom line and not theirs; mutual funds are sold by commission (strong sales incentive by front line staff) and the management fees on the funds investment are charged without regard to the whether the investment appreciates in value. Investors go to the banks for advice, not just to purchase funds, and they deserve to be treated fairly, not advised to purchase funds which benefit the bank more than the investor. Those "investment managers" are frequently sales representatives with a fancy title. This situation reminds me of the old saying that one should not go to a snake oil salesman to learn about herpetology.

Therefore when it comes to protecting individual investors I am all for government intervention. We should not all need to be financial experts and do extensive research to determine if the pieces of paper being waved in our faces are nothing other than a way to fleece us of our money. Due diligence is always recommended -- I am not arguing for making investing idiot proof -- but the banks' worst and egregiously misleading and deceptive practices should be curtailed. Structural separations of the banks, or even breaking apart the conflicting lines of business into independent companies, may have its place, even if it's a blunt instrument when more careful measures may be preferable. As with all these matters, enforcement is key, and at least breaking apart the investment banks, by virtue of so crudely impeding method for the banks to benefit from conflicts of interest, does make downstream regulatory oversight easier.

However, and even vehemently, this should not be the case with professional money managers. If competent and not engaging in outright criminality, they should have the skills and resources to be wary of and see through the conflicts of interest of the banks they go to for advice. After all, many have previously worked for the banks, and they have completed and passed certification programs to ensure they are capable.

This struck me when I read this Business Week article about the seeming incompetence of municipal financial managers when it came to selling municipal bonds.

Underwriters have an incentive to raise the interest rates on the bonds to make it easier to resell them to investors, while officials want to borrow money at the lowest cost. A bank acting as a financial adviser may persuade a municipality to sell the securities in a negotiated sale or laden them with high-fee derivatives, steps that could make them more profitable but may not be in the best interest of taxpayers.

The article goes on to note that the banks must resign as advisors to the municipalities before selling the bonds because of how easy it is for the banks to benefit from those conflicts. But, again, remember that the banks' customers in this case are professional financial managers who should, and do, know better. There is something terribly wrong here, and it is not just the banks.

I suspect that one reason why this might happen is that there is another type of transaction that the municipalities and banks are engaged in, and that is with the buy/sell roles reversed. The state or municipal financial managers invest employees' pension funds with the same banks. This is a buy-side transaction (the opposite of the bond sales). It is perfectly reasonable to question whether there can be some inappropriate linkage between these two very different business deals between these parties, one where they each scratch the other's back.

As pure speculation I wonder if the municipal managers would accept a higher interest rate on bonds if the banks also promise higher returns on pension funds investments? If suitably rated, those investments would give the appearance of quality, and therefore give those managers the ammunition they need to promote the deal with their employers. I think this is a question worth asking now that those investments have gone sour, along with the rest of the asset-back commercial paper market, and the pension funds are in some distress, which impacts the quality of the bonds they sell through the banks.

No investors appeared to have been harmed. "New Jersey has never failed to pay a bond holder and never will," said Andrew Pratt, of the state Department of the Treasury. The state "aims to have the best bond disclosure in the nation and will continue to strive to achieve that goal," he said.

Whether the SEC uncovers simple incompetence (where the banks pulled the wool over the eyes of negligent municipal financial managers), bank malfeasance, or criminal collusion between the parties, there will be lessons to be learned. The ratings agencies, that are also under scrutiny, have played a role by putting their positive "opinions" on the paper that the municipalities bought. Even if we can eliminate banks and ratings agencies from involvement, there is some regrettable action on the part of states and their municipalities, not just their financial managers.

The funds are the largest of seven funds in the $66.9 billion New Jersey retirement system. Among other things, the SEC said, the state didn't disclose it had abandoned a five-year plan to fund the pension plans. The pension system covers 689,000 current employees and retirees.
...
[New Jersey] revalued its assets in 2001 to create the benefit funds but used values from 1999, at the height of the tech bubble.

Are the governments themselves or their financial managers, or perhaps both, acting with deliberation or incompetence? Incompetence is conceivable since, as civil servants, they earn less than in private industry -- the investment banks -- and that may be because they didn't make the cut. It could also give them an incentive
to act inappropriately when given an opening by the banks.

As a spectator in all of this I can only repeat a cliche about investing, which is to only invest in what you understand, and even then dig as deep as you can to find out the truth. This goes for professionals and individuals alike. Relying on the advice of the bank selling you mutual funds, GICs and other investments does not count as due diligence. As a final note I suggest, if at all possible (and it always is for the individual investor, though not so easily for large institutions), only invest in liquid instruments so that at the slightest whiff of nastiness you can get out, fast.