29.6.2012 Ernst Grönblom

Inside Job – Only America’s Problem?

HCP Equity Strategies and ESG

After the Movie

Congratulations; you understand now more about financial markets than 99% of the population. How does it feel – are you angry? According to a Time-magazine movie critic: ”If you’re not enraged by the end of this movie, you haven’t been paying attention.” Official Trailer YouTube buy DVD Amazon UK

At HCP we concur. Although the movie exaggerates and simplifies things at times, unfortunately the facts presented are true. At HCP we agree with the movie’s message: the values of the financial world stands on a jittery ground. At the same time we want to say openly that we do everything we can to be worth of our customers’ trust.

Questions

 (1) Before, someone in need of a mortgage would go see a banker, who, after carefully evaluating the person applying for the mortgage, would grant the person a mortgage. One of the main causes of the financial crisis were the so called sub-prime mortgages, which were sold to people in weak financial situations and often completely without collateral – in other words, to people who would never have been able to get a mortgage in normal condition and to whom mortgages can be harmful. What explains this change in the mortgage business? Why did the professionals close their eyes from the facts and granted mortgages to people, who would not be able to pay them back?

HCP’s view: the biggest factors influencing the changes in the practices were commissions. The old time bankers, mentioned before, would have to live with the credit decisions made for years, even decades: loans were part of the company’s balance sheet and defaults on loans could very well end a bankers career. The sub-prime mortgage brokers knew that the mortgages would be sold forward as soon as the mortgages were signed, meaning that if the borrower was to default, someone else, other than the broker, would have to bear the consequences. Also, the broker was paid a commission based on the number of mortgages sold. For the brokers, the incentive was to sell as many mortgages possible without caring about their quality. The distorted commission fees and incentives were not limited only to brokers. The entire system from the brokers to the investment banks securitizing the mortgages, and from financial advisors to mortgages funds were encouraged to maximize the number of mortgages – not their quality.

(2) Are there any financial instruments in Finland today with questionable benefit for the buyer, and which might be dangerous?

HCP’s view: Yes. Even after 5 years since the beginning of the financial crisis, tens of billions of euros worth of financial securities are sold to customers that, we think, are designed to profit the sellers on the expense of the customer, without the customer knowing about it. Good examples are structured instruments (such as index notes and other collateralized products) or, the so-called, closet index funds.

Structured instruments often consist of a low risk interest component and a high-risk derivative component. In layman’s words, structured securities are like portfolios that come with insurance (for example, insurance guaranteeing that the value of the portfolio will only be able to drop a maximum of 20%). This sounds appealing, but the problem is the price of the insurance, which is often unreasonably high for the customer. The complexity of the products guarantees that customers will have a hard time understanding the real value of the security.

The following simplified example enlightens the issue: let’s assume you have a car worth of 10,000€. You know that you crash your car once in every 20 years (inversely it can be derived that the probability of you totaling your car is 1/20 = 5% in a year.) What is a reasonable price for an insurance that covers you totaling your car? A reasonable price is comprised of the expected value of the damage plus expenses (handling fees, margin etc. let’s say the damage + 20%). In this situation, the expected damage is 10,000€ x 5% = 500€. If additional expenses are added, we get 500€ + (500€ x 20%) = 600€. A reasonable price for insurance would be approximately 600€. If the price is significantly higher than that, the insurance company is most likely trying to fool the customer. Let’s say, if the insurance offered costs 2,000€ a year, everybody can do the math and realize that the insurance company is trying to take advantage of the customer. On the other hand, a buyer of a structured security is like a car owner buying insurance, but who has no clue of the value of his car or the probability of the possible accident. Additionally, if he is still shocked from a recent accident (like almost every investor who experienced the financial crisis) it is unimaginably easy to sell 2, 5 or 10 times more expensive insurance policies. A banker should have the morals of a saint in order to resists the temptation to take advantage of this situation; I don’t think we have to mention that bankers who can resists the temptation are rare.

On top of the fact that structured securities are often sold alarmingly expensive, they also carry a high counterparty risk (for example, if the bank goes under, the customer can lose everything), which is often underrated.

Closet index funds are an example of another questionable financial innovation that is in wide use. Closet index funds are mutual funds that are promoted as active funds, but judging by their strategy and structure (investments in hundreds of securities) are de facto index funds. These funds combine the worst parts of active and passive investing: the high expenses of active investing and the low returns of passive investing. A large portion of equity funds marketed by big banks and mutual funds meet these criteria.

(3) What drives the sellers of these products to market them to customers?

HCP’s view: Just like with sub prime mortgages, we think the answer is distorted commission fee policies. Kickbacks or incentives are according to the Finnish Securities Markets Act fees or other benefits paid or given to a third party related to an investing- or other financial service. Often kickbacks are paid or received when a asset manager invests in a third party fund or structured instrument, leaving the asset manager to operate as the middle man. It is common in the industry that the fund pays back to the asset manager a portion of the commission it received (management fee or performance fee). A kickback is a commission fee, which is used to reward the middleman (asset manager). It is not wrong to use commission fees and for example the retail industry lives through commission fees. The problem arises if commission fees are paid without the customer knowing of it, as it can have damaging effects on the service the customer gets.

Kickbacks are very common in the financial industry and form a key component of the total income for several banks and asset management companies. Kickbacks paid in the financial industry have at least three harmful side effects; a) they lower the total return of the client’s portfolio; b) they create a hidden expense, which makes it difficult for the client to understand the total fees charged and to compare different funds and asset management services and c) what we think is the biggest problem, they create an agent-principal-problem caused by distorted incentives between the customer and the asset manager.

Kickbacks encourage asset managers to maximize the received kickbacks instead of looking after clients’ best interest by maximizing the value of the portfolios. We think that kickbacks distort the asset manager’s objectivity and independence. Kickbacks and the problems related to them are not widely discussed. One reason to the silence around this issue might be that the subject is abstract and unknown to the majority of the clients. It can also be assumed that the people working in the investing industry prefer to keep the general public unaware of the issue, in order to benefit from it financially. The Finnish Competition and Consumer Authority stated on 3.3.2006 that it “strongly opposes” kickbacks in the financial sector – but after half-a-decade after the announcement, things are unchanged. HCP thinks that the prevalent kickback policy in the industry is unethical. As far as we know, HCP is the only asset management company in Finland, which has agreed in its customer contracts, to return all kickbacks and similar benefits to its clients.

(4) The movie depicts how the banks packaged the sold sub-prime mortgages with other loans to form a collateralized debt obligation (CDO). CDOs were sold forward to professional investors (insurance- or pension funds, mutual funds and other banks). CDOs were complex securities and their structure was very difficult to comprehend. Why didn’t anybody question these complex structures?

HCP’s view: The initial reason for securitization was to diversify risk, which is one principal pillar of investing. CDOs were so complex securities that their structure and the real risk of the securities were almost impossible to understand even by professionals. The complexities of the securities lead to an illusion that risk had disappeared. Hitherto, it seems that the banks creating these securities and the buyers buying them started to believe that there was no risk present, since there was no risk to be perceived. Complex securities can also be sold at a premium price, because customers can’t properly price the securities. Sometimes complexity cannot be avoided, but almost always it is unnecessary.

 (5) Are so complex financial securities sold in Finland that it is difficult to understand the real risk, features and expenses of the security?

HCP’s view: Yes. An example of a complex group of securities is the previously mentioned structured securities. The most common security of this type are the capital protected notes. At their best, they return a poor profit and are expensive. According to a Swedish research, the expenses of the capital protected notes offered by big banks are 5 – 8% for four years, which is very high considering the expense is for a single transaction. When a bank has been able to sell a capital protected note worth of 100,000 euros, the bank instantly receives 5,000 – 8,000 euros without the customer noticing. Obviously this practice is not wealth management, but product selling.

 (6) Why do you keep talking about moral? I don’t care about my wealth manager’s morals as long as he invests my money profitably! Isn’t it enough?

HCP’s view: Many people, who are about to hire an expert, seem to think that the best choice is “a tough guy”: who cares about morals anyways? For example, when a person is looking for help in a tricky lawsuit, one often looks for a “fox”, who knows all the dirty tricks. This is all perverted; if I hire as my lawyer a cunning person, what stops him from using his knowledge and “tricks” to take advantage of me? Behind the financial front-page scams (Madoff, Wincapita etc.) and every-day scams (structured securities, closet index funds etc.) are often very intelligent people. This fact didn’t help their victims – actually the opposite! An intelligent thief can cause a lot more damage than a stupid thief.

The wealth manager’s morals and ethics are values that a potential customer should find out first. Only after the potential customer has found out whether to trust the wealth manager or not, should the investing skills be evaluated.

(7) How can I make sure I will not be played like the people in the movie? What should I demand from my wealth manager?

HCP’s view: Mutual trust is the core of successful wealth management. If a wealth manager loses the customer’s trust, there is no return to a functioning relationship. The movie lists distorted incentives and commission policies as the biggest causes of the 2008 catastrophe. Although the biggest overkills occurred mainly in the U.S., the same problems were visible in the old continent, including Finland. HCP’s policy to return all kickbacks to customers is a way to solve the problem of distorted commission policies. Internally at HCP we have solved the problem by having our professionals working as partners, in which case their personal income is dependent on the company’s long-term performance (which is highly correlated to investment success due to our fee structure), not short-term bonuses. HCP is the first, and as far as we know, the only asset management company in Finland that has in its customer contracts agreed to return all kickbacks and similar benefits to customers . The movie also shows how banks ruthlessly bet against their customers. The professionals at HCP (and some of their family members) have invested their own money in the same strategies in which the funds operate.

Epilogue

The movie is very critical and most likely will cause people to completely lose their trust for the financial sector. Through this movie, we want to bring up the weaknesses of the system, but at the same time we want to state that HCP has been operating the way the movie wishes financial industry to operate already before the 2008 crisis. HCP’s operations are based on transparency, establishing long-term customer relationships and especially on mutual trust. We welcome you to join us in building a better financial industry: HCP initiative.

HCP Equity Strategies and ESG