Professor Explains Financial Crisis, Part 1

In his January 24th New York Times column, Six Errors on the Path to the Financial Crisis, Alan S. Blinder, professor of Economics and Public Affairs at Princeton University, briefly summarizes the causes of the Financial Crisis. He uses a chronological approach, listing the decisions (and the alternative advice that was ignored).

According to Blinder, the cause of our troubles “was largely a series of avoidable — yes, avoidable — human errors. Recognizing and understanding these errors will help us fix the system so that it doesn’t malfunction so badly again.”

Here is a summary of his article.

Wild Derivatives. Rather than regulate these arcane financial instruments, as Brooksley E. Born, then chairwoman of the Commodity Futures Trading Commission recommended in 1998, “top officials of the Treasury Department, the Federal Reserve and the Securities and Exchange Commission squelched the idea. … Does anyone doubt that the financial turmoil would have been less severe if derivatives trading had acquired a zookeeper a decade ago?”

Sky-High Leverage.  In 2004, the S.E.C. let securities firms raise their leverage sharply. Had leverage stayed at previous levels, “these firms wouldn’t have grown as big or been as fragile.”

A Subprime Surge. “The next error came in stages, from 2004 to 2007, as subprime lending grew from a small corner of the mortgage market into a large, dangerous one. Lending standards fell disgracefully, and dubious transactions became common.”

Foreclosures. “The government’s continuing failure to do anything large and serious to limit foreclosures is tragic. …Free-market ideology, denial and an unwillingness to commit taxpayer funds all played roles. Sadly, the problem should now be much smaller than it is.”

Letting Lehman Go. “The next whopper came in September, when Lehman Brothers, unlike Bear Stearns before it, was allowed to fail. … Everything fell apart after Lehman.”

“After Lehman went over the cliff, no financial institution seemed safe. So lending froze, and the economy sank like a stone. It was a colossal error, and many people said so at the time.”

TARP’S Detour. “The final major error is mismanagement of the Troubled Asset Relief Program, the $700 billion bailout fund. … Instead of pursuing the TARP’s intended purposes, (Henry M. Paulson Jr., the former Treasury Secretary), used most of the funds to inject capital into banks — which he did poorly.”

Conclusion

Six fateful decisions — all made the wrong way. Imagine what the world would be like now if the housing bubble burst but those six things were different: if derivatives were traded on organized exchanges, if leverage were far lower, if subprime lending were smaller and done responsibly, if strong actions to limit foreclosures were taken right away, if Lehman were not allowed to fail, and if the TARP funds were used as directed.

All of this was possible. And if history had gone that way, I believe that the financial world and the economy would look far less grim than they do today.

The Fama/French Blog

Two prolific and very well respected Finance professors, Eugene F. Fama of the University of Chicago Booth School of Business and Kenneth R. French of the Tuck School of Business at Dartmouth College, have a blog worth noting: the Fama/French Forum. Their blog covers Finance and Economic Policy

Here is a recent Q&A on Recessions.

Question: The US economy is in a recession. Does it make sense to own stocks during a recession?

Answer: There is no evidence that market timing in response to economic events enhances expected returns. The market tends to lead economic activity. Stock prices tend to fall in advance of recessions and rise in advance of economic upturns. To time markets successfully, you have to come up with better forecasts of economic activity than those already built into stock prices. We don’t know anyone who can do this.

Moreover, investors who try to time the market by selling after news of a recession is already in prices are probably reducing their expected returns. Although realized returns are too volatile to make strong statements, there is some evidence that expected stock returns are relatively high during recessions and low during expansions. One can avoid the higher risk of stocks during recessions, but apparently only by passing up higher expected returns. —EFF/KRF

What We Can Learn from Madoff

“Bernard Madoff was able to pull off what is allegedly the largest investor fraud in history because people trusted him. But why did people believe his lies when there were so many reasons not to?” – Blaine F. Aikin.

For a full month, I have avoided writing anything more about Bernard Madoff; not because there was nothing new to say, but because it seemed that there was so much readily available about the tragedy.

However, an article in the January 18, 2009 edition of Investment News is worth highlighting. What We Can Learn from Madoff  by Blaine F. Aikin discusses how a proper fiduciary investigation should have and did raise many red flags.

Here is a summary:

Good fiduciaries are necessarily skeptical, so they sought verification of key information before they would invest. Their due diligence paid off; they uncovered troubling information in six areas of essential inquiry for fiduciaries.

First, Mr. Madoff didn’t use an independent custodian.

Second, his financial auditing was provided by a tiny, obscure accounting firm.

Third, Mr. Madoff produced his own performance reports and wouldn’t allow independent performance audits.

Fourth, the extraordinary investment success claimed for the fund didn’t jibe with reasonable investment benchmarks, and the results couldn’t be substantiated when subjected to fundamental testing of the trading strategy.

Fifth, the business structure of the fund made little economic sense. Moreover, it seemed designed to avoid regulatory oversight and to frustrate due-diligence efforts by prospects and clients. Rather than organize as a hedge fund and charge a lucrative performance-based fee, Bernard L. Madoff Investment Securities LLC operated as a commission-based broker-dealer with distribution provided through hedge funds of funds.

Finally, he showed little appreciation for, and no processes to apply, fiduciary standards of care. … He rejected potential investors who asked penetrating questions, reacting to such inquiries as an affront to someone so accomplished in creating wealth.

Conclusion

There were many hedge funds which invested their clients’ money with Bernard Madoff. The hedge fund managers collected sizable fees for being conduits or “feeders.” Amazingly enough, they claim that they did their homework and investigated Madoff thoroughly. One firm in particular was quoted in the New York Times on December 14th defending their actions.

The Fairfield Greenwich Group “performed comprehensive and conscientious due diligence and risk monitoring,” Marc Kasowitz, a lawyer for Fairfield, said in a statement. “FGG, like so many other Madoff clients, was a victim of a highly sophisticated massive fraud that escaped the detection of top institutional and private investors, industry organizations, auditors, examiners and regulatory authorities.”

Now, Fairfield is seeking to recover what it can from Mr. Madoff.

The fraud was long lasting, and the red flags should have been apparent. Some investment managers completely missed the warning signs. But not all. According to Blaine Aikin, “a number of dedicated fiduciaries, including several large financial institutions, investment advisers, retirement plan sponsors and endowment administrators, found Mr. Madoff’s magical ability to generate consistently stellar returns to be too good to be true.”

Financial Literacy, Part 2

“What good is it if high-school students learn about Flaubert, biology, and trigonometry if they don’t learn how to take care of their money?” – Stephen J. Dubner.

In my last post, I discussed the importance of access to financial education and advice for everyone.

A post by Stephen J. Dubner, co-author of Freakonomics, asks a very provocative question: Are We a Nation of Financial Illiterates? 

He asks:
1. Do you consider yourself financially literate?
2. If so, how did you get that way?
3. How important is widespread financial literacy to the health of a modern society?

Dubner believes that financial literacy is a very important issue (obviously, or he wouldn’t have written the article).

To assess your own competence, answer Dubner’s three sample questions, which have, by the way, been used in national surveys. Note that only 1/3 of respondents 50 and older got all three questions right!

His prescription for increasing financial literacy is derived from an interview with Annamaria Lusardi, a professor of economics at Dartmouth. Given yesterday’s inauguration of Barack Obama, of particular interest is her answer to the question, “If you were president of the U.S. for a day (or longer), what are 5 pieces of financial literacy that you’d try to have taught to everyone?”

Dubner provides his own answer to that question.

Financial Literacy, Part 1

Given the state of the global economy, the need for financial literacy should be self evident. Life is complicated. And in that complicated life, we all must make sometimes difficult choices, based on the best information we can gather and our interpretation of it.

But, according to a column by Robert Shiller in yesterday’s New York Times, that knowledge is sorely lacking. In How About a Stimulus for Financial Advice?   Shiller extols the benefits that would be derived if the government subsidized the financial advice and education that the majority of people desperately require.

Shiller discusses several studies which prove that lower-income consumers are no match for the sophistication of financial service providers. Some of the revelations are quite shocking. Take his example of payday loans. You probably get spamvertisements for them in your email box all the time. But did you realize that  “payday loans — advanced to people who run out of cash before their next paycheck — exploit people’s overoptimism and typically succeed in charging annual rates of interest that may amount to more than 7,000 percent.” You read that right, 7,000%.

Shiller focuses on the need for financial education specifically for those less fortunate, because, in his reasoning, wealthy folks already have access to good advice. I, however, would say that we all need more education, sophistication and good advice; case in point, the billions of dollars lost by wealthy “educated” investors in the Madoff scam.

To confirm that you too need objective advice, ask yourself (or check your records) how much money is your financial advisor making from you? I can pretty much guarantee that your financial service provider knows the answer to that question, probably to the penny. See my previous posts on why it is not in his or her best interest for you to know that answer.

Here are some relevant quotes from the Shiller article.

In evaluating the causes of the financial crisis, don’t forget the countless fundamental mistakes made by millions of people who were caught up in the excitement of the real estate bubble, taking on debt they could ill afford.

Many errors in personal finance can be prevented. But first, people need to understand what they ought to do. The government’s various bailout plans need to take this into account — by starting a major program to subsidize personal financial advice for everyone.

A number of government agencies already have begun small-scale financial literacy programs. For example, the Treasury announced the creation of an Office of Financial Education in 2002, and President Bush started an Advisory Council on Financial Literacy a year ago. These initiatives are involved in outreach to schools with suggested curriculums, and online financial tips. But a much more ambitious effort is needed.

The government programs that are already under way are akin to distributing computer manuals. But when something goes wrong with a computer, most people need to talk to a real person who can zero in on the problem. They need an expert to guide them through the repair process, in a way that conveys patience and confidence that the problem can be solved. The same is certainly true for issues of personal finance.

One wishes that all this financial cleverness could be focused a bit more on improving the customers’ welfare!

The theory of capitalism, going back to Adam Smith over 200 years ago, sees an alignment of interest between consumers and businesses. Only those companies that produce what consumers really need will succeed. Those that do not will be beaten in the marketplace as consumers shop elsewhere. This puts pressure on providers to innovate and to better satisfy consumer needs.

This theory assumes, however, that consumers are rational in their choices, and to a large extent they are. But in some areas, notably personal finance, it is important to recognize that a good share of Americans have difficulty figuring things out.

Most people get financial advice only from sales representatives of one sort or another: real estate agents, mortgage brokers, sellers of financial products. Some of these providers could use their sophistication to exploit people’s tendency to behave irrationally, and to manipulate the judgment errors that consumers typically make. And competitive pressures tend to make providers promote products that exploit those errors to the hilt, unless, of course, we offer consumers real financial advice.

Conclusion

Shiller acknowledges that there is no silver bullet to the issue of financial education and risk taking. However, “it’s still likely that advisers who built long-term relationships with their clients, and who pledged to look after their welfare, would have been a helpful influence, suggesting caution to those who were getting over their heads in debt, and warning that adjustable-rate mortgages could be reset upward, just as the fine print said. For these reasons, financial advisers probably would have reduced the severity of the housing bubble.

Professional financial advice is now generally accessible only by the relatively wealthy. Changing this would be an important corrective step. Giving the general public access to trained advisers would be a boon for the nation in this time of doubt and distrust.”

Shiller raises some very good points. He envisions a government subsidy to help pay for one-on-one financial counseling. I personally believe that part of the needed education and counseling could be delivered with a combination of classes and individual consulting, in order to keep costs down. But I am with him entirely when he says that advisers should have long-term relationships with their clients and that advisers should pledge to look after their clients’ welfare.

A previous post discusses the desirability and practicality of working with someone who is a fiduciary, as opposed to a registered representative.

Frugal Times: Why and How to Save More.

You’ve probably heard this a hundred times over the past year: Spend less and save more money. Obviously, that’s great advice. But just how do you do it? M.P. Dunleavey’s brief article in the January 9, 2009 edition of The New York Times, Making Frugality a Habit, answers that not-so-simple question, first, though, giving some useful context.

Actually saving some money — let alone the thousands you might need to weather a crisis — results from a chain of habits and choices that does not, for many people, come naturally.

Among the families surveyed for the study, 75 percent “couldn’t survive for three months, if they had to do it on savings alone.”

My husband and I could easily be one of those families. Every time our emergency fund hits the one-month mark some crisis strolls along and gobbles up our funds. Then we start over. Now, I am determined to save the $15,000 that would cover our family’s most basic needs for at least three months.

A few tricks that might help. Start by finding a specific chunk you can save — perhaps cutting back cable, quitting smoking, renting out the garage or limiting spending on restaurant meals.
THEN do an end-run around your own inertia and use automatic transfers to deposit a set amount — $100, $200 or $300 — every month into an account not linked to your checking and definitely not accessible by PIN or with any piece of plastic. The first time I tried this, I saved $3,000 so fast it made my wallet spin.

So take care of yourself in this rocky economy. Fear can be a powerful motivator, but so is the lure of knowing that you have created some peace of mind.

25 Ways I Save Money, an older blog post at Cash Money Life, lists 25 very specific (and quite useful) ideas on how to cut expenses – some so basic, you’ll wonder why you didn’t think of it first!

Conclusion

We all know that having an emergency fund makes sense. Creating that emergency fund is another matter entirely. What doesn’t make sense, though, is to set yourself up to fail from the onset. What I mean by that is you should set an obtainable, realistic, end goal and make regular, realistic, contributions to get there. Hopefully, these articles will be enough to get you motivated.

Stockbrokers in the Spotlight

You may recall a series of articles that I wrote not too long ago about the potential perils and pitfalls of working with stockbrokers, also occasionally referred to as “registered representatives.”

An article in the January 13, 2009 edition of The Wall Street Journal, Help Wanted: Wall Street Stockbrokers, No Joking, explains just how well some “high-producing” stockbrokers are compensated. (Note, in this case, the description “high-producing” refers to how much revenue they generate for their employers.)

For a somewhat jaundiced (and funny) post on this particular issue, see Milo Benningfield’s article, Stockbrokering: Who Said Retail Wasn’t Profitable?

Benningfield, by the way, is a fee-only financial advisor located in San Francisco. Here’s a summary of his post.

Now that investment bankers and traders have proven such great disappointments to the large Wall Street houses, they’ve taken renewed interest in their retail brokerage operations. And what lucrative operations they are.

Naturally, Wall Street wants to take care of these golden geese.

As ‘registered representatives’ of the brokerage firm, stockbrokers (as they are informally called) are legally bound to represent the interests of the firm, not the client, in any transaction. (Registered reps/stockbrokers should not be confused with ”registered investment advisers,” who have a statutory duty under the Investment Advisers Act of 1940 to put the client’s interests before their own.)

In other words, stockbrokers are a distribution channel for the brokerage firms, and it makes perfect sense that the firms would want to protect and support that channel by offering brokers huge financial incentives.

But all the largess heaped upon the brokers does raise a question: just how are the Wall Street firms, who apparently need a government bailout just to stay in business, expecting to recoup the “partner awards” and other incentives that they’re currently “doling” out to stockbrokers?

To answer that question, dear customer, all eyes are upon you. Caveat emptor, my friend.

Caveat emptor – buyer beware. As always, that’s very good advice. If you’d like to read more about this subject, read The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William J. Bernstein. Pay particular attention to Chapter 9, entitled “Your Broker Is Not Your Buddy.”

Caveat emptor, indeed.

Managing Your Own Investments, Part 1

“Tens of millions of investors need personal guidance; other tens of millions do not.” -
Jack Bogle.

In my last post, I recommended what I consider to be two very helpful books for those investors who have decided that they want to engage a financial planner to manage their investments. Reading either or both of these books before you have your first consultation with the prospective advisor, will provide you with a checklist of the right questions to ask him or her.

The knowledge you will gain will also arm you against misleading claims some advisors may make; for example, that the funds they recommend “outperform” the market. There is no evidence that anyone can consistently “beat the market.”

Suppose that, after realistic introspection, you have decided that you definitely want to manage your own investments. Perhaps you do not want to give up the control to someone else. Or you are convinced that you can do a better job yourself. If that is indeed the case I suggest that you start by educating yourself. To that end, let me suggest several books that will help you become your own investment advisor.

Obviously, I won’t waste your time suggesting any book that purports to have a strategy to consistently outperform the market or promises to avoid losses, and you should be very skeptical of any such claims.

Here are three books that are a very good place to start.

The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William J. Bernstein

The Only Guide to a Winning Investment Strategy You’ll Ever Need: The Way Smart Money Preserves Wealth Today by Larry E. Swedroe

Live It Up Without Outliving Your Money! – Getting the Most From Your Investments in Retirement by Paul Merriman

These books all reach similar conclusions, primarily about the need for diversification and risk management, though they obviously present their authors’ differing perspectives. To some extent, these are overlapping, but all are useful. If I had to choose just one book, it would be Bernstein’s. It covers the Theory of Investing, the History of Investing, the Psychology of Investing and the Business of Investing; all-in-all, a well-rounded, intelligent read.

Some Cautionary Notes

Keep in mind that designing a portfolio is just the beginning. You will still need to implement your investment plan and to monitor it regularly. And you will need to keep up with changes in tax policy as it affects your investments.

Often, the most difficult aspect of being your own investment manager is the psychological part – namely, sticking with your plan. It’s too easy to second guess yourself, and you will not have a behavioral “coach” to help you avoid big (i.e. costly) mistakes.

Nevertheless, taking the time to read these books will not go to waste. As my wise mother used to say, “Knowledge is a light burden.”

Making Better Financial Choices, Part 2

“Poor asset allocation, ill-considered active management, and perverse market timing lead the list of errors made by individual investors.”- David Swensen.

In my last post, I suggested that a great many investors would benefit from a financial advisor who could help them create and implement a comprehensive financial plan and who can manage their investments. Whether or not you heed my suggestion depends on whether you consider yourself a do-it-yourselfer or a delegator.

To handle your own investments, you must first know yourself. Be honest. Do you have the time, inclination, and emotional fortitude to do this right?  Successful investing takes both knowledge and discipline.

Do you understand risk management, asset allocation and asset location? Are you capable of writing and sticking to an Investment Policy Statement?

Perhaps you’ve shot yourself in the foot one too many times? It happens to a lot of novice (and not-so-novice) investors. Many individual investors tend to be too enthusiastic after market prices have gone up and go into a buying frenzy; conversely, they become overly pessimistic after market prices have fallen and then are anxious to sell.

If you realistically doubt your investment skills, then you are a delegator, someone who will rely on a professional to invest your hard-earned money for you. If that is the case, you should be looking for an investment manager who will listen to your needs and goals and implement an investment strategy that makes sense to you and for you.

In my opinion, and I’ve said this numerous times, you should only work with someone who has your best interests at heart – and that means someone who is a fiduciary.

The most common arrangement in working with a Registered Investment Advisor (RIA) is to pay an annual fee, which is based on a percentage of assets, though some financial advisors do work on a retainer basis.

If you are not clear on what fees you are paying, or if your prospective advisor cannot explain what fees you will be paying, you are most likely working with a stockbroker or insurance agent, i.e. someone who receives a commission. I cannot and do not recommend this approach for two simple reasons: It is not transparent, and there are possible conflicts of interest.

For most individuals, the investment management or retainer fee is well spent, because you will avoid the costly mistakes that most investors make. Since the manager will be both an implementer and a behavioral coach, it is crucial that you understand and accept his or her investment philosophy.

Trusting someone to manage your personal investments is one of the most important decisions you will ever make. Here are two books I recommend that you read in preparation for your search for an investment manager.

Simple Wealth, Inevitable Wealth (3rd Edition) by Nick Murray

Wise Investing Made Simple by Larry Swedroe

Notice that both books have the word “simple” in the title, but don’t let that mislead you, investing is not a slam dunk. As Warren Buffet is quoted as saying, “Investing is simple, but not easy.”

Making Better Financial Choices, Part 1

New Year’s Resolutions are often included as a part of every individual’s holiday tradition. My own resolution – not new, because it’s the same every single year – is to get more exercise. In general, though, resolutions don’t have a good record of success. Even as you’re reading this now, it’s likely that many of your own resolutions have already been abandoned.

But, if your resolution was and is to make better financial decisions in 2009, I applaud you. It’s an honorable and worthy goal, and one that can be achieved with relatively little pain. Helping individuals to make better financial decisions, so that they maximize their chance of achieving their goals: That’s my professional objective; it’s also another of my perennial resolutions, but one I faithfully keep.

Rather than writing my own killer “Top Ten Things to do to Get a Grip on your Finances,” I did a Google search on what has already been written. There’s an amazing amount of stuff out there on the net, some of which is quite basic – spend less, save more, have an emergency fund – but still apropos. There is one standout among the crowd, The Best Financial Advice Ever by Liz Pulliam Weston.

Assuming you already know the basics, here is an excellent article: 10 Resolutions to Fix Your Finances by Allan Townsend.

Although the last update was more than a year ago, this Money Central article is still a keeper. It definitely goes beyond the basics.

No. 1: Set up a system.
No. 2: Bank online.
No. 3: Take stock of what you own.
No. 4: Get out of debt.
No. 5: Create a budget.
No. 6: Review your 401(k) plan.
No. 7: Check your insurance coverage.
No. 8: Check your estate plan.
No. 9: Don’t give your money to Uncle Sam.
No. 10: Make new goals.

You’ll either find this list “old hat” or quite intimidating. There are links to further information on the various suggestions, and if you’re at all confused by what you’ve read, I urge you to read on.

Conclusion

For most people, developing a financial plan is well worth their time. Just as you plan a vacation, by carefully selecting a destination based on your needs, wants and desires, and determine the best way to get there given your individual situation, your financial decisions should involve the same type of strategic thinking.

After reading Townsend’s article, you may decide that you need help in analyzing your current situation, your required savings, and in developing a long term strategy. Thinking strategically and monitoring your results regularly will let you know if you are on track to reach your goals.  It will also indicate when you need to adjust your existing financial plan to match your new or changing financial situation.

It may not be easy to set up a financial plan by yourself, but you needn’t do it alone. A good financial planner will help you analyze where you are and what you need to do to achieve your goals. For most people, having an experienced financial advisor prepare a comprehensive financial plan is well worth the time and money.

Although you may be very successful in your own field of expertise, you may not have the time or inclination to keep up with changing tax laws and new investment products. There is no shame in delegating these tasks to someone who does them full time. You may also not have the discipline to manage your own investments, and there’s no shame in that, either.

The key is to start immediately. You need to harness your motivation now, create a plan and then begin to take the steps to implement it. A good planner will outline all of the steps required to reach your goals.