I saw last week that Merrill Lynch and Citigroup were in the news again for the exotic mortgage-backed investments that have helped to screw up the credit markets. Merrill sold off nearly $31 billion of the investments for just 22 cents on the dollar. Citigroup is expected to write down $8 billion because of its involvement in these crazy investments.
Lots of analysts and reporters are talking about how these losses reflect the trickiness of the financial markets and how these collateralized debt obligations were risky ventures from the start. But I don't think that's really the lesson to take from these announcements.
It didn't take a genius to see what was happening. The big investment banks created a bubble, not unlike the tech bubble of a few years back. Everybody knew that eventually the bubble would burst and that things would get ugly. Everybody knew these investments were risky. But the investment banks ran into them head-on. Why? Because of their compensation system. There was the potential to make huge sums of money in commissions, so they were incentivized to take on huge amounts of risk.
The investment banks also felt bullet-proof. They figured that they were too big to fail, and that the government would bail them out if they got into trouble. In other words, you and I would be on the hook if things went south.
A money manager at one of these investment banks has an incentive to take as much risk as he can with other people's money. He gets paid for gathering assets, and the more assets he brings in, the more he gets paid. The way to bring in more assets is to show outstanding performance over a short period of time and get publicity in the major financial magazines. The way to show outstanding performance in the short term is generally to take on excessive amounts of risk.
By taking that extra risk, the money manager puts his clients in position to lose a lot more down the road -- but the manager doesn't care. Why should he? He doesn't get penalized as a manager for the losses his clients get; he gets paid for the assets he brings in.
This shows the systemic problem behind Wall Street's compensation structure. Whether you're talking about these exotic investments such as CDO's or the way that fund managers handle your funds, it doesn't matter. Wall Street types are incentivized to put their interest ahead of yours, and they do not suffer the same consequences as you do when you lose money.
These managers are paid handsomely and are widely regarded as the best in the business. They're supposedly geniuses. But if they can screw up their own companies so bad, do you really want them managing You, Inc.?
The moral is clear. When Wall Street appears in genius mode, raking in huge profits on mysterious products and complex trades, the secret isn't genius at all. It's that hubris is running wild, and so is risk. And whether it's tomorrow or five years hence, risk will jump from the shadows, knife in hand, to cut genius down to size.
-- Shawn Tully, editor-at-large, Fortune Magazine
If you've been reading my blog or newsletter for a while, you probably know that I have six principles underlying my investment philosophy. Number One is "Most investments are designed to make Wall Street rich, not you," and everything else just cascades down from that.
I think the credit and liquidity problems we're seeing now is a fallout from the greed on Wall Street, and it's a prime example of why I advocate managing your own money. You are uniquely qualified to do it, assuming that you are properly educated. The good news is that it's not hard to learn. It's not a big mystery that takes years and years to decipher.
Even if you choose to have someone else manage your money, you still need to be educated. A properly educated investor is subject to the least amount of conflict-of-interest and can better distinguish between a good investment and a clever sales pitch.
Educating investors is what I do, and helping people succeed is what I love. If you're ready to take the reins of your own portfolio, or if you just want to be a more educated investor so you can make better, more informed decisions, let's chat. Give me a call at 214-245-5236, 1-888-6SNIDER, or send me an email.
1. Story, Louise, "Write-Down Is Planned at Merrill," The New York Times, 29 July 2008. [accessed 30 July 2008]
2. Dowell, Andrew and Ed Welsch, "Merrill Deal May Cause Banks to Revalue Debt," The Wall Street Journal, 30 July 2008. [accessed 04 August 2008]
3. Tully, Shawn, "Wall Street's Money Machine Breaks Down," Fortune, 12 November 2007. [accessed 01 August 2008]
Kim Snider is the President and Founder of Snider Advisors, an investment adviser registered with the SEC, focused on teaching individual investors a sensible, long-term investment approach focused on maximizing cash flow. For more information on Snider Advisors or the Snider Investment Method, please visit snideradvisors.com. Her book, How to Be the Family CFO: Four Simple Steps To Put Your Financial House in Order, will be in bookstores October 1, 2008.
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