Wall Street's biggest firms are considering the suitability of selling opaque financial products to governments, endowments and not-for-profit institutions after the contracts magnified credit-market losses that plunged the U.S. into a recession.
“There is no distinction among very different groups of investors, and this is where things might change,” said Dino Kos, a managing director at Portales Partners LLC in New York and former head of the Federal Reserve Bank of New York's open market operations. “Wall Street cannot pretend anymore that the treasurer of a small town in the Midwest on a civil service salary and no analytical support has the same level of sophistication as a specialized hedge fund.”
Any restrictions on the sale of derivatives, which are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or the weather, would “at least initially” reduce earnings because “it would be harder to sell higher-margin products to some customers,” said Kos, who worked at the New York Fed for 22 years beginning in 1985 before a nine-month stint at Morgan Stanley.
While securities laws differentiate between the financial transactions companies can sell to individuals and to institutions, there's growing recognition that local governments and endowments shouldn't be equated with hedge funds, according to four Wall Street executives who spoke on the condition of anonymity because their firms haven't made any decisions.
The soul-searching was triggered in part by a Securities and Exchange Commission lawsuit against Goldman Sachs Group Inc. for allegedly failing to inform a German state bank and New York-based collateral manager ACA Management LLC about the role of hedge fund Paulson & Co. in a mortgage-linked security.
Goldman Sachs shares have dropped 23 percent since the suit was filed, compared with a 15 percent decline in the Standard & Poor's 500 Financials Index.
While Goldman Sachs executives have said that the firm did everything it was legally required to do, Chief Executive Officer Lloyd C. Blankfein, 55, was castigated at a U.S. Senate subcommittee hearing in April for selling securities linked to subprime home loans even as the firm's traders were betting against the market. On May 14, the firm said in a statement that its business standards committee will review practices including “the suitability of products for different types of clients.”
Lucas van Praag, a spokesman for Goldman Sachs in New York, said he couldn't comment further.
Harvard Sees Crimson
Municipalities and universities across the U.S. have paid hundreds of millions of dollars to terminate interest-rate swaps sold by banks on variable-rate debt after interest rates, instead of climbing, fell to record lows in the worst credit crisis since the Great Depression.
Harvard University in Cambridge, Massachusetts, used $467.6 million from a bond sale in December 2008 to end $1.1 billion of existing and forward swaps and agreed to pay an additional $425 million over 40 years to reverse another $764 million of swaps for capital projects it has delayed or canceled.
Swaps, which are derivatives designed to keep monthly interest payments low as lending rates change, also soured for local governments, including those in Jefferson County, Alabama, and hill towns in the Umbria region of Italy.
JPMorgan Chase & Co., the second-biggest U.S. bank by assets, agreed to a $722 million settlement with the SEC in November to end an investigation of the bank's derivatives sales to Jefferson County without either admitting or denying wrongdoing. The firm paid a $25 million penalty, gave $50 million to Jefferson County and agreed to cancel $647 million in fees the county faced to unwind the transactions.
Alabama's most populous county has sued JPMorgan, alleging fraud, conspiracy and “unjust enrichment against those who have brought the county and its citizens to the brink of financial disaster while lining their own pockets.”
In Pennsylvania, state Auditor General Jack Wagner has asked lawmakers to repeal legislation passed in 2003 that allowed school districts and local governments to enter into swaps, which he said are “tantamount to gambling with taxpayer money.” In April he said the state's turnpike commission would lose $145.7 million, almost three months of toll revenue, if it had to terminate its swaps on more than $2.23 billion in debt.
U.S. securities laws differentiate between investment advisers, who operate under a “fiduciary duty” toward their clients, and brokers, who are required only to determine whether an investment is “suitable.” While the fiduciary duty obliges advisers to put clients' interests ahead of their own, the suitability standard entails ascertaining that customers are able to understand and withstand the risks.
The key assessment in determining suitability is the amount of money controlled by the client. Customers with more than $1 million in investable assets are deemed more sophisticated than those with less. Above $100 million, there's little distinction between institutions, whether they're city governments or investment companies such as BlackRock Inc.
While the definition of sophisticated hasn't changed in decades, Wall Street has been selling increasingly complex products, such as swaps, auction-rate securities and collateralized debt obligations like the one at the heart of the Goldman Sachs case.
Even some Wall Street bankers didn't understand the risks they were taking. Lehman Brothers Holdings Inc., the fourth- biggest U.S. securities firm, went bankrupt in September 2008, and two of its rivals -- Bear Stearns Cos. and Merrill Lynch & Co. -- were sold to larger banks to avoid collapse. Fannie Mae and Freddie Mac, the two biggest U.S. mortgage-finance companies, insurer American International Group Inc. and Citigroup Inc. all relied on government bailouts.
The financial reform bill that passed the U.S. Senate last month attempts to address sales of swaps. The legislation, which needs to be reconciled with a version passed by the House of Representatives in December, would require swaps dealers to adopt a fiduciary duty in dealings with state or local governments, endowments and pension or retirement plans.
Although the measure is designed to protect taxpayers who end up footing the bill, it has been opposed by state treasurers. In a May 16 letter to Christopher Dodd, the Connecticut Democrat who chairs the Senate Banking Committee, the National Association of State Treasurers said suitability requirements, not fiduciary duty, should apply to dealers.
“While swap counterparties and brokers must have a responsibility to determine the sophistication of the government entity and to determine the suitability of a swap transaction for that entity, it would be inappropriate to impose a fiduciary responsibility on swap counterparties and brokers,” James Lewis, president of NAST and treasurer of New Mexico, wrote in the letter.
Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York who has served as treasurer of Morgan Stanley and chief financial officer of Lehman Brothers, said imposing such a fiduciary duty on brokers would mean they would stop doing business with “protected” clients in the over-the-counter, or OTC, market, where most derivatives are traded and higher fees are charged.
“It's very unlikely that an OTC derivatives desk will ever deal with a client as a fiduciary in an OTC market,” said Hintz. “A fiduciary is expected to owe the duty of loyalty to his or her client and must not profit from the fiduciary position.”
Instead, Utah State Treasurer Richard K. Ellis said he sees a need to create a new suitability test for how interest-rate swaps are sold to debt issuers, such as water districts. Ellis, who sits on the board of the $18 billion Utah Retirement Systems, said the state pension fund has ample sophistication to analyze and use interest-rate swaps. Utah has avoided them when it comes to managing its own debt program, he said.
“We've been pitched on interest-rate swaps as long as I can remember,” said Ellis, who served as deputy treasurer for nine years before becoming treasurer in January 2009. “We've always told them no, and sometimes they've walked away and said, ‘You guys are country bumpkins, you just don't get it.' I'm really glad to say I'm a country bumpkin right now. We never did get involved with them. We just didn't see that the risk-return there was enough for us.”
Wall Street executives say it's inevitable that the industry's behavior will change. Firms are going to be more careful determining which institutions can undertake the detailed analysis required to understand investments, they said.
Attempts to define which investors are more sophisticated than others can be fraught with difficulty and may restrict investors' choices unfairly, said Russell Sacks, a partner at law firm Shearman & Sterling LLP in New York.
“There are some very sophisticated and professional municipal and pension fund managers and some less sophisticated hedge-fund managers,” Sacks said. “At some point you run out of tests for sophistication, and you have to rely on the representations of the person in front of you, the qualifications of the person in front of you, and, as imperfect as it is, the assets under management of the person in front of you.”