January 24, 2017
What We’re Reading This Week
Sometimes something bad/stupid is happening and you can sort of tell that it’s bad or stupid but so many people are also doing it that you have to wonder if you’re wrong and you should just go ahead and do it too. No, I’m not talking about quinoa or Twitter, I’m talking about investing in subprime mortgage debt during the lead up to the financial crisis. Deutsche Bank recently agreed to pay $7.2 billion of restitution for misleading investors about the quality of its mortgage debt. This is the largest penalty like this to date and comes with the obligatory comments from Washington, “Wall Street is bad…Banks are evil,” etc… Reading through the Department of Justice’s notice, it sort of seems like Deutsche Bank had some concerns about the debt too but you know, all the other banks were doing it. There is some logic to that though. It’s easy to infer that the department at the bank responsible for packing mortgage debt probably just had that one responsibility. When all you do is sell mortgage debt and all the mortgage debt available for you to package is garbage you might stop and say, “What is everyone else doing?” It turned out everyone else was repackaging it. You then have two options, go to work but stop doing the one thing you were hired to do or just go along with everyone else (simplified). Sure, from that perspective it is a tale of Wall Street greed, however I also think we may have taken this too far. According to Principal Deputy Assistant Attorney General (Seriously?) Benjamin C. Mizer, “The Bank’s conduct encouraged shoddy mortgage underwriting and improvident lending that caused borrowers to lose their homes because they couldn’t pay their loans.” Errr, sorry – Deutsche Bank didn’t force people to borrow money they couldn’t pay back. Remember when that woman sued McDonalds because her coffee was too hot and everyone thought she was crazy? Well, this is just like that. The loans are the coffee and the Department of Justice is acting like the woman as a proxy for borrowers. Or, at least they are holding themselves out as such. The reality is that misrepresenting mortgage debt mostly affects large institutional investors. Granted, individuals sometimes invest through these institutions and these people were hurt by the bad investments but saying, “This huge company lied and caused this other huge company to lose some money,” isn’t nearly as satisfying as saying, “This bank is evil.”
If going along with everyone is sometimes wrong and stupid then not going along is also sometimes wrong and stupid. Last week I talked about bond covenants and how they mostly never get read. Well, it’s been a big few weeks for bond documents and they are finally getting their day in the sun. There is language in the Trust Indenture Act of 1939 that says: “The right of any holder of any indenture security to receive payment shall not be impaired or affected without the consent of such holder.” Marblegate Asset Management, LLC took this to mean that bond restructuring deals are illegal even though no one has thought that since 1939. That’s a big assumption on my part, I’m just sort of guessing the law has been in place since 1939 because, you know, its name. Well, briefly, a court agreed and Marblegate thought all the time and legal fees were worth it. And they were, until they weren’t. Earlier this week the US Court of Appeals overturned the decision and said Marblegate was being silly. It turns out that the rule only applies to the bondholder’s ability to get paid, not any other aspect of the debt. The resounding response from the bond industry was, “Yeah, we know.”
This topic is near and dear to my heart. The Department of Labor has created a fiduciary standard for investment advisors that requires them to act in a client’s best interest. I really like this idea because really, something is better than nothing and many advisors find it is more lucrative to act in their own best interest. Many advisors are against this as it will be harder for them to charge higher commissions and sell proprietary products. They have lots of reasons why they are opposed to the new standard but it all comes down to wanting money. There is one solid argument against the fiduciary standard. Or at least, there are some unintended consequences. Basically, you can’t force people to act in a client’s best interest, you can only enforce penalties for advisors that don’t act in a client’s best interest. It will never be a perfect mechanism but it will at least be a step in the right direction.
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