Bank Stocks the Next Tech-Bubble?

It comes as no surprise that the subprime/credit crunch crisis has led to an increased level of securities class action filings. Research firm Cornerstone just released a report which shows the financial sector was the target of the most filings with 63 in the first half of 2008 alone. The research is an indication that many believe there are disclosure issues which led to inflated stock prices.

But another area of concern is that brokers made speculative plays in these stocks on behalf of their retail clients. Sensing a bottom, many brokers loaded up their clients with stocks like Citigroup, Merrill Lynch, and even Bear Stearns. Trying to catch a falling knife is not an appropriate recommendation for an investor with amoderate or conservative risk profile and we are seeing such complaints become more common.

Clearly, brokers fell asleep at the wheel on two levels: there was no reasonable basis for expecting the financial services industry was finished with its subprime write-downs unless they were duped nor was there any reasonable basis for many investors to buy financial stocks during the past year and a half.

During the tech-bubble, we filed many claims on behalf of investors whose brokers pushed them into bottom fishing for tech stocks that were rightly beaten down. This is another example of Wall Street’s history repeating itself.

Needless to say, any broker who recommended buying bank stocks in the past year and a half should be prepared to explain their rationale in an arbitration hearing.

The Hapless Members of Citi’s ELKS Club

It’s only a hunch, but experience tells me you can soon expect to be reading a lot about “ELKS” and other structured investments in the business press.

The name evokes images of a hardy, austere and stable animal able to withstand the harsh elements of the forest. But not in this story. For some Citigroup customers, ELKS might conjure images of a broker who duped you into buying risky securities that were inappropriate with your investment goals.

Citi’s ELKS (equity linked security) product is a risky derivative instrument where an investor is offered a specified return on a structured security tied to an individual stock. Providing the stock maintains a minimum value, the guaranteed return is paid. If the stock ever falls below the minimum value (sometimes around 80 percent), the ELKS immediately convert into shares of that stock. Then if the price of the underlying stock declines, the investor could receive a stock worth much less than the initial investment.

Here’s the catch: ELKS offer potentially higher returns, but the downside risk is unlimited if the stock goes south. If the underlying stock happens to dramatically increase in value, the investor only gets the guaranteed return.

For Citigroup, it’s a classic case of “heads I win, tales you lose.” The bank charges investors an upfront commission to buy ELKS and likely earns additional profits through hedging. Not surprisingly, brokerage firms were aggressively peddling structured derivative products like ELKS to unsophisticated retail investors a few years back, prompting FINRA to warn member firms of concerns that customers didn’t understand the inherent risks.

There’s evidence that FINRA’s warnings weren’t heeded. I represent a retired couple over 80 whose Citi broker last year bought $300,000 worth of ELKS on their behalf. The ELKS were highly unsuitable for retirees simply looking to preserve capital. The highly volatile stocks my client’s ELKS were derived from included Yahoo!, Cemex and Sandisk. The couple has lost nearly a third of their principal as the underlying stock’s value plummeted.

Admittedly, I have only encountered one ELKS case so far, but many brokerages firms peddled similar products using monikers such as PACERS, STRIDES, SPARQS, and ELEMENTS. Some commentators were critical of me when I sounded the early alarm about auction rate securities, but that warning proved quite prescient. Recall, that the SEC uncovered wrongdoing in the ARS market in 2006, but the activity persisted. Sadly, I can’t help but suspect that the experience of my elderly clients with ELKS is not an isolated incident.

Stay tuned.

The Piety of Henry Blodget

Henry Blodget and I have a history, there’s no denying that. Back in 2001 I sued him and his former employer Merrill Lynch for fraudulently touting tech stocks that Mr. Blodget privately confided were “POS,” “pieces of junk” and “pieces of crap.” My case caught the attention of former New York Attorney General Eliot Spitzer and ultimately led to the $1.4 billion global settlement and Mr. Blodget’s lifetime ban from the securities industry.

Although countless investors lost hundreds of millions of dollars because of his bogus research reports (and he was allowed to keep most of the millions of dollars he was paid to write them), Mr. Blodget has refused to fade from the limelight he once enjoyed. He has successfully transformed himself into a prolific journalist, penning commentaries in august publications such as the New York Times and running various websites including Clusterstock, which specializes in stock research. Given his disgraced past, that takes real cajones.

Last week Clusterstock launched a mild broadside at yours truly, questioning my transparency though essentially conceding the merits of my argument regarding a blog post I wrote on some failed Citigroup hedge funds. The site says Mr. Blodget agrees that “it is possible” that I’m correct in speculating that Citi’s brokers were likely instructed to market the collapsed hedge funds as conservative investments “but he would like see evidence of this.”

Mr. Blodget understands full well how the game is played, particularly since Merrill’s brokers dutifully peddled his research to clients, even when they began to openly question the integrity of his analysis. Furthermore, the Wall Street Journal recently quoted a Smith Barney broker as saying, “”That’s why they bought it,” said the broker whose clients, many of them wealthy retirees, invested in the Falcon fund. “These kinds of clients weren’t looking for a home run.”

Interestingly, Mr. Blodget remained mum on my comment that Citi was positioning its own brokers as fall guys, when in all likelihood they were merely following the direction of the company’s wealth management executives. I’d expect this comment to strike a particular nerve given that Mr. Blodget took the fall for Merrill’s conflicted research while his senior managers was given a free pass. As I noted in my earlier post, Wall Street’s senior executives almost never are held accountable for the wrongdoing under their watch.

Finally, there is Mr. Blodget’s issue with my transparency:

Since Zamansky is taking a stand for “transparency,” Blodget thinks it might also have been appropriate for Zamansky to disclose that he is in the business of suing companies based on allegations like the ones above.

Setting aside the irony of Mr. Blodget requesting transparency, my interests in the Citi hedge fund post were patently obvious. But in deference to Mr. Blodget’s new found piety, I must point out that in my blog post I referenced angry calls from investors who are my clients. If that wasn’t clear enough, my biography is clearly posted on Seeking Alpha, a financial blog aggregator which is where Mr. Blodget originally saw my post. And finally, my blog post first appears on my law firm’s website.

Most people in the industry know – Mr. Blodget certainly one of them – that I represent investors who have been harmed and abused by Wall Street.

Suffice to say, I never thought I’d see the day when I’d be holding myself accountable to Henry Blodget. Perhaps that explains the pigs I’ve just seen flying past my office window.

Falcon Falling: Citi’s Hedge Fund Litigation Problem

I’m no expert on public relations, but I’d expect the flacks at Citigroup would go to great lengths to avoid maligning the firm’s Smith Barney brokers. But the financial giant’s public defense for peddling risky proprietary hedge funds to wealthy clients seeking conservative investments implicitly undermines either the integrity or the competency of the firm’s brokers.

“Our disclosures and marketing material sufficiently outlined the inherent risk in the funds and their leveraged strategies,” an unnamed spokesman said in a statement issued to the Wall Street Journal regarding the firm’s Falcon and ASTA/MAT hedge funds, which have lost about 75 percent of their value in the past year.

Oh really? Well if the disclosures were so sufficiently outlined, then how come I’m getting calls from outraged clients who vehemently insist they bought into the hedge funds because they were repeatedly assured by their brokers that the funds were extremely low-risk investments? Smith Barney brokers themselves apparently are even willing to acknowledge that these assurances were given. I quote verbatim here from The Wall Street Journal:

Citigroup brokers and fund managers assured prospective investors that the new hedge funds were low-risk, with Falcon likely to post losses of no more than 5% a year in the worst-case scenario, according to people familiar with the situation.

“That’s why they bought it,” says a Smith Barney broker whose clients, many of them wealthy retirees, invested in the Falcon Funds. “These kinds of clients weren’t looking for a home run.”

Investors rely on the overtures of their brokers, who fashion themselves as financial consultants or advisors, not highly compensated salespeople. “We make money the old-fashioned way. We earn it” – as Smith Barney used to say.

Unfortunately, most brokers don’t have the training or the acumen to understand highly complex and sophisticated financial instruments. So they dutifully rely on the representations given to them by their superiors, who are richly compensated for moving the products out the door.

Herein lies the vicious circle: Citigroup concocts inherently risky funds for its brokers to sell to their wealthy clients that generate handsome fees for the firm and commissions for its brokers. The brokers are told to market the fund as a “conservative” investment, notwithstanding that fact that the funds are so levered that a few ticks the wrong way causes the house-of-cards to collapse. The brokers mimicked the company’s recommended sales pitch to their clients and successfully wrangled hundreds of millions of lucrative assets.

Citigroup, understanding that it has a significant legal liability on its hands, publicly insists that company sufficient disclosed the risks when it marketed the funds. If that was truly the case, the brokers who marketed the funds will deservedly be held legally accountable for failing to educate their clients about the obvious risks.

But more than likely, many of the Smith Barney brokers who marketed the funds themselves were likely led to believe the funds were in fact “low risk.” At a minimum, there was a lack of due diligence. Now that markets are under pressure, Citigroup wants to shift the onus of blame to its brokerage force, rather than hold its wealth management executives accountable. Blaming the folks who followed orders – rather than the ones who gave them – is the way Wall Street works.

Chairman Waxman’s CEO Compensation PR Stunt

Next month, Congress will be schlepping in the former chief executives of several financial services firms damaged by the subprime crisis to question them about their compensation packages. House Oversight and Government Reform Chairman Henry Waxman (D-Calif.) has sent letters to Angelo Mozilo, CEO of Countrywide Financial, Charles Price, former CEO of Citigroup and Stanley O’Neil, former CEO of Merrill Lynch. According to reports Chairman Waxman intends to ask them why they “stand to collect tens of millions of dollars in severance payments and other compensation,” even as their current and former companies are losing billions of dollars in the subprime mortgage meltdown.

It’s certainly understandable to perceive these golden parachutes as obscene. Mr. Mozilo is supposedly getting more than $110 million on top of the $47 million he got last year, while Countrywide Financial erased billions of dollars in shareholders equity. Mr. Prince is allegedly getting more than $29 million in “accumulated benefits” and supposedly even received a bonus for 2007. Mr. O’Neal walked away with more than $161 million in “accumulated benefits.” Citigroup and Merrill together have written down more than the GDP of most third world countries.

By any measure, paying these men hundreds of millions of dollars for their recent performance is not justified – which is exactly why Mr. Waxman is calling in the wrong people. It should instead be the corporate board members overseeing the compensation committees that should explain the payouts. Maybe executive compensation consultants hired by corporate boards should face questioning too, such as Hewitt Associates of Lincolnshire, Illinois, and Mercer Human Resources, which were involved in the decision to give Dick Grasso over $100 million. The ones who accepted authorized pay shouldn’t be flogged.

The individuals Chairman Waxman should have sent letters to include Harley Snyder, CEO of HSC, Inc., John Finnegan, Chief Executive Officer of The Chubb Corporation and Alan J.P. Belda, Chairman and CEO of Alcoa, who chaired the compensation committees of Countrywide, Merrill Lynch, and Citigroup, respectively. Hopefully not lost on Chairman Waxman would be the fact that all these men hold the title of CEO. In this elite fraternity, sometimes one hand washes the other. For example, Mr. O’Neil was just named to the board of Alcoa. It would of course be too obvious of a conflict for Mr. Prince to serve on Alcoa’s board, so Mr. Belda got the next best thing. The point is, those holding the power don’t have the motivation to change the status quo.

Chairman Waxman needs to get to the source of the problem which lies squarely with the board of directors and compensation committee members. Not holding them accountable is like patching a leaky roof with duct tape every time it rains. Unfortunately, without their presence next month’s hearings are the equivalent to nothing much more than a witch hunt wrapped-up in a PR stunt.

If Chairman Waxman was truly interested in relating compensation to performance, why stop at publicly held companies? He should call in sports stars like Alex Rodriguez, Carl Pavano, and Albert Belle, notoriously over-paid underperformers. I know what you’re thinking. Congress holding hearings with professional baseball players sounds ridiculous, doesn’t it?

The Subjective Nature of Wall Street Write-Downs

Fourteen billion. That’s the apparent magic number for Merrill Lynch and its new CEO John Thain as formally they announced a write down of $14 billion for the fourth quarter of last year. An equally staggering number was announced by Citigroup and its new CEO Vikram Pandit, which wrote-down $18 billion for the fourth quarter. Together their losses amount to more than the Ecuadorian GDP! It is of course strategically logical for Mr. Thain and Mr. Pandit to write-down such massive losses. As incoming CEOs the losses weren’t under their watch and they can ride gains to the upside. No where to go but up from here!

But what is more troubling about Merrill’s and Citi’s write downs is how it exemplifies the subjective nature of Wall Street’s accounting methods. Just one quarter ago the write-down was $8 billion for Merrill and $11 billion for Citi. Both of those write downs occurred during the tenures of the now “retired” CEOs Stan O’Neil and Charles Prince, respectively.

I have a few questions: If the previous CEOs were still in place would the fourth quarter numbers have been the same? Did Mr. O’Neil and Mr. Prince choose to take smaller write downs in an attempt to save their jobs or is Mr. Thain and Mr. Pandit taking a bigger write down than necessary to ensure they receive the full extent of the upward bell curve? Or are you going to believe “uncertain market conditions” are to be blamed?

The point is, strategy shouldn’t influence when and how much to write down losses. What Wall Street’s earnings environment shows us is that a CEO may have a greater influence on balance sheet than, well… the balance sheet.

In an ideal world we would count on an independent accounting firm to honestly audit Wall Street’s books. But accounting firms are anything but independent as noted by Francine McKenna, whose blog re: The Auditors covers the “Big Four” accountancies. In a recent post, she disclosed the lucrative relationship between PricewaterhouseCoopers (PwC) and Goldman Sachs. PwC has been Goldman’s sole auditor since the firm went public in 1999, but they deliver a myriad of other professional services to the firm.

Writes Ms. McKenna, “This past year, total audit fees were $43.4 million, audit related fees were an additional 3.3 million and tax fees were 2.6 million. In addition, [PwC] made $19.2 million more by providing services to merchant banking and other funds managed by Goldman Sachs subsidiaries. All of these fees were for audit and tax services. By comparison to prior years’ numbers, we can see that over the years, and like other large, complex, global companies, audit and related fees have grown substantially due to Sarbanes-Oxley. But the services to the Goldman Sachs funds have also been part of the package since almost the beginning and add a significant amount to PwC’s overall compensation.”

What Ms. McKenna delicately touched upon I will say outright: with money like that at stake an accounting firm is not incentivized to interpret accounting rules strictly and universally. More plainly, either Mr. Thain or Mr. O’Neil has some explaining to do because investors should not accept that Merrill Lynch couldn’t have written down any of the $14 billion before now.

The game is clearly rigged in Wall Street’s favor if a CEO has billions of dollars of leeway when it comes time to pay the piper. With such grey accounting standards, the write-downs are largely meaningless. And therein lies the lesson. When investing in Wall Street, you’re on a wing and a prayer.