Pointing out the Obvious

I wrote this for the 1-2 Knockout blog, but it is reposted here, enjoy:

Pointing out the Obvious

Over the course of the past year, I've spoken with a large number for brokers/financial advisors at my firm, and while I attempt to give them the benefit of the doubt, often I am left disappointed by their ignorance of most things finance (especially things that don't add to their bottom line). Just the other day, I spoke to a financial advisor (intentionally lower-case, btw) who asked if I knew if we published any research on Bear Stearns, so he could read it and advise his client(s). Besides the fact that this genius lacked the ambition to literally make 4 mouse clicks to navigate the intranet site to exactly where he wanted to be, I found this situation to be exemplar of far larger issues at hand. On the surface, this points out what for many in the Financial community is already a foregone conclusion, that retail brokers are wholly unqualified to offer any sort of financial advise.

Historically, financial advisors and brokers have offered various investment products such as equities, 'straight' fixed-income (corporate, preferred, muni, etc), annuities, and insurance. While I strongly doubt the ability of any financial advisor to value such a simple product as an annuity, Brokerage firms generally provide various planning tools allowing their advisors to simplify this process and explain returns, risks, etc to their clients when selling these traditional products. However, today (and this is not new, by any means), advisors routinely sell clients on various structured equity and fixed-income products that are far more complicated to value and understand than traditional investment products. Somehow (and this is another issue altogether) advisors are able to pass their NASD (FINRA) licensing exams, yet in my experience more often than not, do not understand these structured products in which they are investing their clients money. How many brokers and advisors are going to read a prospectus for a leveraged principle-protected structured note tied to the value of a basket of currencies with an embedded call option on them? Further, how many could say, model the cash flows or even sketch a chart of the payoff profile of such a security, let alone discuss the specific economic conditions which could affect such an investment?

I'm curious as to what liability a Firm has in such cases. Admittedly, I'm no Lawyer, but it seems to be the case that arguably the only protection Brokerage Firms have in this respect is the ignorance and indifference of their clients. Essentially, Brokers are playing the waiting game, betting on the probability that clients won't lose enough money due to (or at least in part to) 'bad' advice (in quotes, as that is clearly a relative term) so as to compel clients to take legal action. Its a liability management policy based almost solely on a hope and a prayer, that future returns will be similar to historic performance, and that nothing 'really bad' will happen.

What we're seeing now though is this lax liability management coming back to hurt the Brokers. Recently, UBS was served with a class-action lawsuit over the marketing of Auction Rate Securities (see WSJ: UBS Sued over ARS). A detailed explanation of these securities is beyond the scope of this post, but essentially they were sold to clients as almost-cash investments which could be redeemed for cash on a weekly (although monthly, and longer-term reset periods exist) basis, while earning an attractive return relative to other liquid cash-like investments (e.g. money market funds). I'm sure the fine print somewhere includes language that the selling Firm in no way guarantees the success of the auctions (i.e. no guaranteed liquidity), but when considered with the actual pitch these products were sold upon, I doubt that this will offer Firms much protection against lawsuits.

What we see now is that for some years, the success of these auctions and the liquidity they enabled - a critical selling point for ARS - was due to the underwriting/offering Banks and Brokerages propping up the auctions on their own account. In the past few months, as these same Banks/Brokers have reallocated capital due to credit market conditions and losses, they have ceased to support many, if not all of these periodic auctions for their clients. Thus, clients who were essentially promised liquidity have none (or some, if they're lucky) and their 'cash' is completely useless to them. As if this wasn't bad enough, Brokers are adding insult to injury and, in their great benevolence, charging clients interest to take out loans using the ARS as collateral. This seems to be the epitome of usurious, bullying behavior and breach of fiduciary duty at best, and criminal at worst (although thats a claim for the lawyers er, courts to decide).

Only time will tell how this class action and subsequent ones that are sure to be filed against other Brokers will play out, but I imagine that it will not work out very well for the Brokers/Banks. I also don't want to focus solely on this issue, since it is simply one example which shines light on the potentially enormous legal liability of ignorant and unqualified brokers and sales policies/procedures/literature which do not accurately explain investment products in their entirety.

Taken further, one could even question why in this day and age, what purpose brokers and financial advisors actually serve, when one could just as easily open an Ameritrade/etrade/etc account and do the work oneself. The reason for the continued existence of the profession though is not due to their specilization and expertise in providing financial advise, but for the same reasons why virtually every other brokerage type business (e.g. realty) exist: laziness and indifference. People don't want to be bothered with the minutiae of managing their finances, of doing due diligence and research on their investments and potential investments. The problem though, is if the advisor can't do that, then why are they trusted to do so, and so handsomely remunerated for services not performed?