Financial Stocks and Bonds: Dot.com Bust Redux

Given that Wall Street peddles securities as if they were microwave ovens, it should come as no surprise that brokers are given aggressive sales pitches to constantly move inventory, regardless of whether it is in the best interest of their customers.  In the mid- to late 90s, the dubious inventory being unloaded was high technology and dot.com stocks whose share prices were artificially driven up by Wall Street’s conflicted and fraudulent research.  Most recently, financial and bank stocks were the touted “sure thing” and customers of the big Wall Street firms who bought the sales pitch have sadly come to realize they were duped once again.

Despite ample risk warnings, virtually all major Wall Street firms in recent months were actively peddling the stocks and bonds of now failed or troubled financial institutions, including Fannie Mae, Freddie Mac, Wachovia, Merrill, Countrywide, Washington Mutual and, of course, Lehman.  Although these companies had real businesses and posted sizeable revenues, they also had mounds of toxic mortgage-related assets hidden on their balance sheets.  Not surprisingly, the stocks of many of these companies are worthless, or worth just a fraction of what they were a year ago.  It has become clear that the earnings they reported - if I may borrow an infamous phrase from Lehman Brothers - “had no basis in fact.”

I garnered the first dot.com settlement from Merrill Lynch that prompted former New York Attorney General Eliot Spitzer to investigate Wall Street’s fraudulent research practices, so I speak with a certain authority about the wrongdoing from that era.  In the dot.com era retail investors were told to bulk up their technology holdings and have a disproportionate amount of their stocks in this sector because they had “nowhere to go but up.”  Similarly, I’m finding that retail investors were encouraged by their brokers to heavily load their portfolios with financial services stocks because they, too, were supposedly undervalued and carried little downside risk.

Sadly, Wall Street specifically targeted retirees and the elderly who were especially attracted to financial stocks because they carried considerably higher yields than those paid by municipal bonds, CD’s and money market accounts.  The preferred stocks of Fannie, Freddie, Wachovia, etc. carried yields as much as 8 to10%. Because they carried the “preferred” moniker, investors mistakenly were told that the securities were safer than common stocks and therefore inherently less risky.  In the case of Fannie and Freddie, investors also were erroneously led to believed that the stocks of these government sponsored entities had the full faith and backing of Uncle Sam.

The financial firms who were paying inordinately high yields on their preferred stocks and bonds were doing so for a reason: they badly needed capital to shore up their battered balance sheets.  But considerable doubt about the health of these institutions was already swirling in the marketplace, hence the reason they had to pay higher rates of interest on their paper.  The very fact that a firm must pay a comparatively higher rate of interest to attract capital is on its own a sufficient warning sign that its securities are inherently risky. Investors who were not told of these inherent risks, particularly those who list “preservation of capital” as their primary investment objective, may have viable legal claims against their stockbrokers.

I’ve also heard from investors whose brokers recently advised them to buy the common stocks of financial institutions and banks on the argument that they were badly undervalued.  Which leads to another issue Congress should investigate: the appallingly bad research that Wall Street peddles to its retail clients.  It’s astounding that nearly all of the analysts at major Wall Street firms failed to foresee the collapse of Lehman. The global $1.4 billion settlement that came in the wake of the dot.com collapse was supposed to ensure that Wall Street dramatically improve the quality of research it provided to retail investors.  There isn’t an iota of evidence to suggest that’s happened.

Financial Institution Preferred Stocks Blow-Up: Individual Investor’s Next Nightmare

Based on the calls we are receiving, an alarming trend is emerging that equals - if not trumps - the magnitude of the auction rate securities scandal.  I’m referring to a growing number of investors with complaints that their broker improperly recommended purchasing preferred shares of financial firms over the past few months.

Financial institutions such as Fannie Mae, Freddie Mac, Washington Mutual, Merrill Lynch, AIG, Wachovia, among many others, issued preferred shares which offered significant dividend payments.  Brokers pitched them as a fixed-income equivalents which attracted retirees seeking stable investments to generate revenue for living expenses.  But after the credit crisis started in mid-2007, financial stocks turned obviously speculative.

The losses sustained by mom-and-pop investors could be staggering.  According to the Wall Street Journal, the combined market cap of the top 15 S&P financial companies was $1.3 trillion, which has been reduced to $1 trillion.  That’s an evaporation of about $300 billion, and it appears we haven’t hit bottom yet.  Many of the so-called experts don’t understand that for every shot-gun wedding or emergency liquidation the Federal government orchestrates on Wall Street, retail investors wake up to gaping holes in their retirement nest eggs.

At a minimum, these investors should have been told to diversify out of preferred shares of financial firms; the fact that some retirees were told to buy more in recent months is truly a horrifying breach of trust.

I can already hear the cat calls.

“Investors should have known better,” they like to say.

But I’ve seen this over-and-over again.  First it was the dot-com stocks, then it was auction rate securities; now its time to worry whether preferred shares of financial firms are next.