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Morgan Stanley, Complex Structured Products… and Nuns

Wall Street never ceases to amaze me. Financial News reported last week that two Catholic nunneries and more than 80 other investors, have filed a lawsuit in London against Morgan Stanley alleging the firm inappropriately managed a complex structured bond it sold them called a “constant maturity swap,” causing an estimated $6.5 million loss.

Specifically, the suit alleges that Morgan Stanley, in cooperation with Saturns, an Irish bank, neglected to redeem the bonds when a mandatory redemption was triggered after they were downgraded in late 2008 as the financial markets imploded. The suit further alleges that Morgan Stanley and Saturns may have deliberately waited to redeem the bonds several months later so that their firms could earn a fee that they otherwise would have lost if the bonds had been redeemed earlier.

In what could be a public relations nightmare, Morgan Stanley is apparently contesting the suit, claiming it sold the the product to Bloxham, an Irish brokerage firm that represented the nuns. However, the suit alleges that the delay Morgan Stanley ostensibly caused prevented Bloxham from hedging losses from the depreciated bonds and thus caused further losses.

While this case is especially shocking given the victims, it’s unfortunately, very common: Wall Street continues to put their own interests ahead of their clients by peddling structured products to retail investors at an alarming rate.

The structured product market is ballooning out of control and is poised to pop.  According to StructuredRetailProducts.com, Wall Street has sold an estimated $30 billion in structured products to retail investors so far this year. Chris Whalen, a risk expert and co-founder of Institutional Risk Analytics, calls structured products the “next investment bubble.”

I’ve advocated that before a structured product can be sold to a retail investor, parties must sign a simple, “plain English,” one-page agreement akin to what Wall Street uses when entering into a derivatives contract, the so-called “Master Agreement.” Obviously, this added measure alone will not solve the problem. The SEC and FINRA also need step up and enforce penalties to the fullest extent possible on those firms that inappropriately sell structured products to individual investors.

So long as the status quo remains intact, individual investors remain extremely vulnerable to Wall Street’s seemingly endless supply of structured products.

Did Morgan Stanley Opt for Fines Rather than Compliance with Conflict Rules?

Earlier this week FINRA announced that it fined Morgan Stanley $800,000 for failing to adequately disclose material conflicts of interest to investors. FINRA alleged that the firm didn’t make required disclosures in research reports about the securities holdings belonging to analysts. Disclosures were deficient in more than 6,500 research reports over a four year period.

As FINRA’s enforcement chief James Shorris put it, “This case strikes at the heart of FINRA’s research disclosure requirements.”

Perhaps, yet FINRA’s penalty amounts to about $120 per infraction–mere peanuts for Morgan Stanley.

Having played a role in the bubble-era investigation into Wall Street’s conflicted tech stock research, and seeing first hand the seedier side of Wall Street’s research, I believe there may be other forces at work. A greater motivation for Morgan Stanley may be that at the end of the day, its far cheaper to pay a measly fine for failing to make disclosures than it is to conduct its business in a conflict-free manner by separating its research from investment banking.

This is nothing new for Morgan Stanley. In 2006, FINRA’s predecessor, the NASD, alleged that Morgan Stanley failed to make analyst disclosures to investors in 22,000 reports. Morgan Stanley was only fined $200,000 for that infraction.

Until penalties are severe enough to be deterrents, Wall Street will continue to push the envelop. For serial infractions on such an important, high-profile issue, that “goes to the heart of FINRA’s research disclosure requirements,” you would think more than a wrist slap is warranted.

I say, throw the analysts involved and their supervisors out of the business and make Morgan Stanley pay an enormous fine. That would certainly make Wall Street think twice about whether to invest in compliance or regulatory fines.

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