MONEY dodd-frank

The Lions of Wall Street Are Finally Obeying Ordinary Investors

Lion tamer

Today is the four-year anniversary of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Has it made our financial system fundamentally safer? Unclear. But one thing about the law is certain: It's forced the financial industry to get much more interested in individual investors.

Even today, a full four years after the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law, it remains unclear whether this massive set of financial regulations has made our banking system fundamentally more stable. But one thing about the law is certain: It’s gotten the financial industry much more interested in individual investors.

How important have mom and pop become to the titans of capital? On Thursday Morgan Stanley reported second-quarter operating profits jumped by nearly half to $1.3 billion. The biggest contributor wasn’t the bank’s investment bankers or traders, but its army of 16,000 financial advisers working with Main Street clients. That didn’t happen by chance, either: Chief executive James Gorman, a former management consultant who took over the storied bank in the wake of the financial crisis, has made a point of made a point emphasizing relatively steady activities like wealth management.

That flies in the face of Wall Street tradition. Historically, so-called Masters of the Universe have earned their status advising on giant mergers or trading bonds, which were far sexier (and more profitable) than telling well-to-do lawyers and dentists which stocks to buy. Then the financial crisis hit. Hot-shot bond traders, who once seemed able to conjure millions from thin air, no longer looked so bright. Meanwhile, blockbuster corporate deals that investment bankers specialize in dried up. The economy has finally bounced back. But relatively calm financial markets combined with new regulations like higher capital requirements and the so-called Volcker rule have made it harder for Wall Street trading machines to regain their glory.

That’s given Main Street financial advisers new prestige. It’s not just Morgan Stanley. Big banking firms like UBS and Bank of America, which acquired Merrill Lynch in 2009, have been racing to poach – and keep – top advisers, offering signing bonuses and other perks, even as they’ve sometimes thinned ranks among bankers.

Of course, for you and me, the $10,000 question is not who’s top of the pecking order but whether advisers’ new stature will mean better treatment for small investors who, to put it mildly, haven’t always been the Street’s top priority.

In some ways, being a chief profit engine could be a curse more than a blessing. The more banks rely on small investors for profits, the harder they’re going to push to wring every last cent out of their customers. There’s some evidence of this already: While big banks used to be satisfied with handling clients’ investments, they’re now leaning on advisers to pitch fee-laden products like loans and credit cards.

The attention that banks give to individual clients hasn’t been evenly distributed, either. Wealthy clients tend to be more profitable. And banks have pushed advisers to focus on these, sometimes at the expense of middle-class investors.

But there’s hope too. On Wall Street profitability eventually becomes clout. Wealth management divisions traditionally haven’t had much. One of the most painful examples: During the financial crisis many small investors got burned after buying instruments known as auction-rate securities, which were supposed to offer the safety of cash but turned out to be illiquid during the crisis. One of the industry’s biggest stars – Smith Barney’s Sallie Krawcheck, then among the highest ranking women on Wall Street – pushed Citigroup to provide restitution to her division’s clients. Instead, she was shown the door. Maybe in the future that sort of thing won’t happen.

TIME Religion

Pope Francis Sacks Entire Board of Vatican’s Financial Watchdog

The pontiff has replaced the all-Italian board of the Financial Information Authority with an international group of new members — including Juan C. Zarate, a Harvard professor and former Bush Administration official

Pope Francis replaced the entire, all-Italian board of the Vatican’s internal financial watchdog Thursday amid clashes over the pace of reform, the Boston Globe reports.

The Financial Information Authority was created in 2010 to combat money laundering and bring the Vatican into compliance with international standards, and Pope Francis has brought a renewed focus on the agency since he was elected over a year ago and made financial reform a priority.

But the board has faced infighting since Swiss anti-money-laundering expert Rene Bruelhart became its director in 2012, capped by Italian Cardinal Attilio Nicora’s resignation as its head in January.

Pope Francis and Bruelhart have pushed for a more international board, with new members hailing from Italy, Singapore, Switzerland and the U.S., including Juan C. Zarate, a Harvard professor and a former official in the George W. Bush administration.

[Boston Globe]

TIME Congress

Lawmakers Optimistic About Mortgage Reform Plan

Senator Tim Johnson, chairman of the Senate Banking Committee, left, and Senator Mike Crapo listen during a Senate Banking Committee hearing in Washington, Feb. 27, 2014.
Senator Tim Johnson, chairman of the Senate Banking Committee, left, and Senator Mike Crapo listen during a Senate Banking Committee hearing in Washington, Feb. 27, 2014. Andrew Harrer—Bloomberg/Getty Images

A pair of senators are hopeful their proposal to wind down government-backed mortgage giants Fannie Mae and Freddie Mac will be put to a vote in the Senate this year, but they face an uphill struggle

Lawmakers said they were hopeful Wednesday that a plan to ultimately replace government-backed mortgage giants Fannie Mae and Freddie Mac and overhaul the nation’s $10-trillion mortgage market will get a vote in the Senate this year, despite an uphill political battle ahead.

The proposal by Senate Banking Committee Chairman Tim Johnson and Ranking Republican member Mike Crapo has the support of the White House, but obstacles remain, including from liberal Democrats, the GOP-controlled House, and lobbyists for Fannie and Freddie. Those companies have seen their share prices plummet since an outline of the reform plan was released Tuesday; actual legislative language will be released in the coming days.

“I’m optimistic this could be the year to get it done,” said Sen. Mike Johanns (R-Neb.), a member of the Banking committee. “I think it is one of the few bills that could actually get to the floor and move with a bipartisan vote.”

“I like what I hear,” said Sen. Joe Manchin (D-W.Va.), another Banking committee member. “It’s going to be great.”

The proposal would wind down and replace Fannie and Freddie—which have long provided an implicit government guarantee to a vast swath of mortgage loans—with the Federal Mortgage Insurance Corp, a system of federally insured mortgage securities through which private insurers wouldn’t receive a government backstop until they took initial losses on mortgage loans. The proposal would also require new underwriting standards, mandating a five-percent down payment for all but first-time home buyers. The proposal comes after a series of hearings last fall and “dozens” of staff-level briefings, according to a Senate Banking Committee aide.

Fannie Mae and Freddie Mac have been extraordinarily profitable since 2008, when the federal government seized them to stabilize a market beset by subprime loans that went bad and helped tank the economy. The White House announced on Monday that the companies could send more than $179 billion in profits to taxpayers over the next 10 years if the terms of their bailout remain intact, more than triple the estimate last year, Reuters reports. Fannie and Freddie together own or guarantee about 60 percent of existing mortgages.

There are significant challenges ahead to complete what White House spokesman Bobby Whithorn called “the biggest remaining piece of post-recession financial reform.” The initial reaction from Senate Democratic leadership was lukewarm, though a Senate aide told TIME that the chances of legislation hitting the floor are “likelier than not.”

“If there was ever a bill where the devil was in the details, this is it,” New York Sen. Chuck Schumer, a member of the Democratic leadership team and the Banking committee, said in a statement. While Schumer said that the principles of reform “seem reasonable,” his staff would not elaborate on any potential sticking points at this time. Senate Democrats on the Banking committee, including Elizabeth Warren of Massachusetts and Sherrod Brown of Ohio, have said they won’t back a plan unless it “guarantees affordable loans for most buyers and includes significant support for low-income rental housing,” according to Bloomberg.

And it remains unclear if it could ever gain traction in the Republican-controlled House, especially in an election year. “I am skeptical of any approach that does not end the permanent government guarantee in the secondary mortgage market,” Texas Republican Rep Jeb Hensarling, who chairs the House Financial Services Committee, said Tuesday. “Such an approach could very well perpetuate the cycle of boom, bust and bailout we tragically just witnessed.”

Consumer activist Ralph Nader said Wednesday on CNBC that the bill is “dead in the water” unless the real estate and housing lobby support it. Sen. John McCain (R-Ariz.), who enthusiastically supports the plan, echoed Nader’s sentiment. “Never underestimate the lobbying power of Fannie and Freddie,” he said.


Investing in China: Handle with Caution

Beijing-Shanghai High-speed Railway Begins Test Run
SHANGHAI, CHINA - MAY 11: (CHINA OUT) A CRH high-speed train leaves Shanghai Hongqiao Railway Station during its test run on May 11, 2011 in Shanghai, China. After 3 years construction, from April in 2008, with total investment estimated at 220.9 billion yuan (around 32.5 billion U.S. dollars), the Beijing-Shanghai high-speed railway begins a one-month trial operation. It is expected to start operation in June this year, with the travel time between the two cities reducing to five hours from the previous 10. (Photo by ChinaFotoPress/Getty Images) ChinaFotoPress—Getty Images

Wall Street hyper-focuses on how fast China will grow this year or next. As it became clear to me on a recent visit there, my first in five years, that’s the wrong question.

I canceled my flight from Beijing to Shanghai to try out the high-speed train, which covers 811 miles — the distance between New York and Chicago — in less than five hours. Amtrak would take 19.

Five years ago Shanghai was too smoggy and under too much construction for me to understand what China’s urban transformation could mean.

To enter the city today is to be transported to a future of massive skyscrapers connected by superefficient subways. Those buildings are filling up. In 20 years, more than 350 million people will have moved from the countryside to cities.

This first-rate infrastructure now supports the world’s second-biggest economy. The real question to ask about China is whether its leaders will act as if that’s what they’re managing rather than relentlessly pursue export growth on the backs of a cheap labor pool.

Related: How to Invest in a Natural-Gas Boom

Ann Lee, author of “What the U.S. Can Learn From China,” argues the answer is yes. “They know that they need to put money in people’s pockets,” she says. As evidence, Lee points to China’s 800 million cellphone users and the 6 million students graduating college each year.

Reforms, yes, but…

Financial reform, such as expanding the role of private capital in the banking sector, is slowly taking hold. Michael Hasenstab, of the Franklin Templeton Fixed Income Group, wrote recently that this could “elevate China from a middle-income to a high-income country” over the next decade.

Yet Shanghai’s stock market trades at one-third its 2007 peak. Concerns remain about political reform, rampant bribery, intellectual-property theft, and the opaqueness of government data.

Those issues make the bull case uncertain. As Canadian scholars Alan Huang and Tony Wirjanto have observed, Chinese stocks carry price/earnings ratios similar to U.S. stocks yet with much higher growth potential.

Too bad you can’t trust the numbers and Chinese stocks are so volatile.

Related: Should I invest in stocks or in a stock mutual fund?

That suggests a conservative approach. A standard diversified portfolio would have about 30% of stocks overseas, and a quarter of that in emerging markets. Your allocation to Chinese stocks would be about 1.4%.

Until China is more transparent, don’t get much more enthusiastic. Still, what can be seen is amazing. Leaving Shanghai, I rode the magnetic levitation train (no wheels or tracks) to the airport. It compresses a 45-minute drive to eight minutes. That’s progress.


Senate Wimps out on Financial-Advice Protection

One of the official goals of the financial-reform bill that the Senate passed Thursday is “to protect consumers from abusive financial services practices.” For all those lofty intentions, however, senators missed an obvious opportunity to safeguard individuals from harmful investment advice.

Where the Senate failed to act was in the standard of care that a financial adviser owes his or her clients.

As it stands, the standard for some financial professionals is what’s known as a fiduciary standard: They have to put their clients’ interests ahead of their own. For others, such as stockbrokers, the guideline is a weaker standard known as suitability: The products they recommend to their clients have to be appropriate for them, but they don’t have to be the best ones at their disposal; given the choice between two investments they might tell a client to make, these advisers can recommend the one that performs worse but pays them a larger commission.

That distinction between the two standards is no problem in and of itself. The problem is that, though the two guidelines have been around for decades, individual investors still can’t tell the difference between them. Furthermore, they regularly overestimate the level of service their adviser actually owes them. People want to believe that the friendly person offering them financial advice has their best interests at heart. Sadly, that’s not always true.

In the post-meltdown debate over financial reform in Washington, one of the ideas that gained some momentum was to simply require a fiduciary standard of care from all advisers who offer personal financial advice. In favor of it were financial professionals that are already regulated by a fiduciary standard, along with consumer advocates; against the change, in general, were stockbrokers and insurance professionals who argued the tougher standard would hamper their business. A few weeks ago, an amendment was offered for the Senate bill which would extend the standard to any professional offering “personalized financial advice.” But the measure didn’t make it into the bill that passed Thursday night. Instead, what went in was a directive for the SEC to study the issue. (To read the exact language, go to page 785 of the bill and read Section 913.)

In this environment, unfortunately, a study is not much more than a way to weasel out of doing something more substantive. The SEC, in fact, extensively studied financial-advice regulation two years ago. So supporters of the fiduciary standard are disappointed by the defeat.

Here’s a statement from Knut Rostad, chairman of an industry group called the Committee for the Fiduciary Standard:

Twenty-three days after Goldman Sachs explained to the entire world, in excruciating detail, how the suitability standard means it’s quite OK to conceal a huge conflict of interest from a client, the Senate overwhelmingly voted their approval and endorsed the Goldman standard for retail clients. This is not the Senate’s proudest moment.

And here’s what Barbara Roper, director of investor protection for the Consumer Federation of America, has to say about the relevant language in the financial-reform bill:

It requires the SEC to waste time and money to study a problem it has already studied extensively. Then it requires the SEC to adopt rules to address any gaps in regulation between brokers and investment advisers, but it denies the agency the authority it would need to address a known gap. As a result, it perpetuates the ability of brokers to dupe unsuspecting investors into relying on them as advisers without requiring them to meet the basic standards that go with being an adviser — a commitment to act in the best interests of the client and to disclose all material information.

Roper says she’s now turning her attention to the reconciliation process between the Senate and House versions of the bill. Rep. Barney Frank (D-Mass.), chairman of the House Committee on Financial Services, has made it a priority to include “a real fiduciary duty in the final bill,” she says, and she hopes Senate Banking Committee Sen. Chris Dodd (D-Conn.), will go along with that.

For investors’ sake, let’s hope so, too.

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Investors Ill-Served by Financial Reform Amendment

Last month, Sen. Susan Collins (R-Maine) told Wall Street titans they needed to put their clients’ welfare above their own. But legislation introduced by Collins on Thursday looks as if it would gut the very safeguards Collins and other senators say they’re trying to enact.

At issue is what’s known as a fiduciary standard of care — the concept that a financial adviser (or any other professional, for that matter) should put clients’ interests ahead of his or her own. If, for example, a broker had the choice of offering you two different financial products, a fiduciary standard would compel the broker to sell you the one that is a better deal for you. The current standard for brokerages, however, is a less-stringent standard known as suitability: As long as the financial product is appropriate for you, it doesn’t necessarily have to be the best deal you can get. So if the broker has a choice of two similar mutual funds to put into your account, he’s free to sell you the one that’s twice as expensive as the other (and means more income for him).

The problem is, as a major Securities and Exchange Commission study has shown, everyday investors are completely confused by the issue. They don’t understand that some financial professionals (brokers) are covered by the suitability standard. They don’t understand that other professionals (registered investment advisers, as they’re known) are covered by the fiduciary standard. In fact, they don’t even understand the difference between the two standards.

Attempting to clean this all up, three senators — Daniel Akaka (D-Hawaii), Robert Menendez (D-N.J.) and Richard Durbin (D-Ill.) have introduced an amendment to the financial-reform bill in the Senate that would require a broker to meet the fiduciary standard “when providing personalized investment advice about securities to a retail customer.”

The fiduciary issue, which may or may not end up being addressed in the financial reform that’s been kicking around Congress since last year, is “the single most important issue in the bill for average, retail investors,” says Barbara Roper, director of investor protection for the nonprofit Consumer Federation of America.

Which is why she was heartened when Collins showed her support for the fiduciary standard by lacing into Goldman Sachs over the issue at a Senate hearing last month.

And which was also why Roper was disheartened Thursday when Collins introduced her own version of a fiduciary amendment. The Collins amendment also imposes a fiduciary standard. But it’s weaker than the one in the Akaka-Menendez-Durbin amendment. And worse, says Roper, it carves out a glaring exception for brokers who sell only mutual funds, variable annuities and certain closed-end funds.

“This amendment,” she writes, “removes the fiduciary duty precisely where it is needed most — where the conflicts of interest are greatest, the investors are least sophisticated, and the sales practices are most abusive. It paints a target on the backs of senior Americans who are most likely to be targeted with abusive variable annuity sales practices.”

Insurance brokers have fought hard against the fiduciary standard, with insurance-industry experts suggesting that it would make it difficult for insurance agents to make a living the way they traditionally have: by collecting commissions on product sales. Roper disagrees, pointing out the language in the Akaka-Menendez-Durbin legislation stating, “The receipt of compensation based on commission or other standard compensation for the sale of securities shall not, in and of itself, be considered a violation” of the fiduciary standard.

Amid the blizzard of amendments being proposed for the financial-reform bill, why is Roper so exercised about this one? Because Collins has taken so much interest in the fiduciary standard, says Roper, other legislators will be likely to defer to her judgment on this issue. “Given how vocal a champion Senator Collins has been about strengthening fiduciary duties on Wall Street,” says Roper, “this is a real disappointment.”

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Financial Reform Roundup: Banks “Built on Sand”

Financial reform news from around the Web:

  • One columnist asks whether it’s too soon for financial reform. He argues that before rushing to pass a bill, Congress should finish investigating the causes of the financial crisis. [The Atlanta Journal-Constitution]

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Why the Goldman Charges Could Hasten Financial Reform

The Securities and Exchange Commission’s civil fraud charges against Goldman Sachs will no doubt help stoke populist anti-Wall Street sentiment. But the specifics of the complaint, if they turn out to be true, are also a blow to the intellectual underpinnings of anti-regulatory philosophy. And it could give Democrats the advantage in pushing their financial reform measures over the top.

Wall Street has looked pretty foolish over the past three years, but there was a certain comfort in knowing that there were a few smart guys who took the right side of the trade. Like hedge fund manager John Paulson, who became famous for his winning “short” position on mortgage securities.

As long as there are people like Paulson willing to bet against market euphoria, the argument goes, markets should be able to regulate themselves, at least most of the time. People won’t be able to sell dubious securities for very long, because the shorts will hop in to make a profit and in the process bring that stuff down. Maybe there weren’t enough Paulsons to prevent the “hundred-year flood” that led to this financial crisis. But the fact that there were a few suggests that the system basically works, and just needs some tweaking at the edges — maybe just some more transparency.

But what if, as the SEC charges, the guys who make the toxic stuff are working with the ones who bet against it? The complaint says that Paulson’s fund wasn’t merely taking the other side of the bet. As explains,

The SEC’s civil fraud complaint alleges that Goldman allowed hedge fund Paulson & Co. — run by John Paulson, who made billions of dollars betting on the subprime collapse — to help select securities in the CDO.

Goldman didn’t tell investors that Paulson was shorting the CDO, or betting its value would fall. When the CDO’s value plunged within months of its issuance, Paulson walked off with $1 billion, the SEC said.

Got that straight? According to the SEC, Goldman devised a financial product and sold it to investors without telling them that someone who had helped them devise that product was betting on its failure. In that scenario, it’s sort of like neglecting to tell a farmer that the hen house you sold him was designed by a fox. notes that Goldman Sachs, in a statement, calls the SEC’s charges “completely unfounded in law and fact.” Earlier this month, the company devoted part of its annual report to shareholders to defending its role in the mortgage-securitization market.

Paulson and his firm aren’t named in the charges, an SEC official told the Wall Street Journal, because they didn’t have a duty to disclose to other investors. (Paulson, by the way, is not related to Henry Paulson, former Goldman CEO and former Treasury Secretary.)

We’ll see what happens. But as of today it’s a lot harder to argue that ruthless competition in markets makes regulation redundant. It’s ruthless out there, all right. But competitive? Maybe not so much.

By the way, if this happened the way the SEC says it did, it probably wasn’t unique. ProPublica and NPR’s This American Life broke a similar story last week about “the Magnetar trade.” It’s a ripping yarn. And there’s already a musical! This pretty much sums the mechanics, with a catchy tune:

Bet Against the American Dream from Alexander Hotz on Vimeo.

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More Money Wednesday Roundup: A Thrifty Trick & Big Bank Failures

Personal finance from around the Web:

  • Fearful of fraud? Of course, you are. In fact, it’s is a sign of successful messaging on the part of the IRS, which seems to make an annual push for publicizing tax fraud cases as the calendar year approaches April 15th. [Economix]
  • If you have ever been in a Southwest Airlines corral for seating, you will probably enjoy AirTran’s latest commercial, which takes the herd of cattle metaphor to a very literal level. [The Consumerist]
  • Never too big to fail: Former Federal Reserve Chairman Paul Volcker scoffs at the notion that banks should think financial reform will protect them from getting shut down. [AFP]

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