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How'd We Get Into This Mess?

by: Prieur du Plessis October 15, 2008    
Prieur du Plessis

Prieur du Plessis

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This post is a guest contribution by Bennet Sedacca,* President of Atlantic Advisors Asset Management.

The question I am asked the most lately is, “How on Earth did we get into this mess in the first place?” The answer, plain and simple, is greed.

I have stated numerous times that markets worldwide and throughout the centuries are dominated by individuals who cannot seem to shake the two simplest of emotions – fear and greed. Markets tend to overshoot in both directions as investors experience these emotions, which is why I live by the mantra, “buy from the fearful and sell to the greedy.”

I can trace the evolution of this greed, during my lifetime, back to a fateful day on May 1, 1975 - a day known as “May Day.” Until that day, stockbrokers charged a fixed commission on all transactions; there was no negotiation. In order to promote competition, the SEC ended the fixed schedule commissions, which had been in place since the signing of the Buttonwood Agreement in 1792 and the origins of the New York Stock Exchange. It is believed that over the next few weeks, commission rates dropped in half.

This was a wonderful event for investors, but a bad day for Wall Street as one of their chief sources of revenue had now started down the road of deflation.

When I began my career as a retail stockbroker in 1981, commission rates were still rather high and with interest rates in the mid to high teens, even bond commissions were high. In fact, the very first bond trade of my career was a sale of $25,000 Sayreville, New Jersey School District municipal bonds, and I was paid a $750 commission (3 percent). As my career transitioned to institutional sales and trading, markets became more transparent and commission rates plummeted even further. I recall my last transaction on the “sell side” in 1997 of $25 million of U.S. Treasury Notes for a commission of $250. Talk about deflation. You can imagine that there is not much incentive to live in a world where you trade $25 million of securities, assume the inherent risks of a trade failing or a mistake being made, and only be paid $250 for that risk. This was no longer a wonderful way to spend my day.

Brokerage firms saw this trend developing and began transitioning the traditional stockbroker into “financial advisors.” Financial advisors would typically advise their clients to diversify their portfolios into various styles, utilizing a group of pre-screened investment managers in “wrap accounts.” So rather than charge commissions on individual securities, portfolios were concocted to diversify their client’s portfolios and still be able to charge fees as high as 3% per year.

As an aside, a couple of the wrap program trading desks were my clients while I was an institutional salesman and, to be frank, I was never that impressed with what I saw being done for clients. This is what led me to becoming a Registered Investment Advisor in 1997. To me, the wrap programs looked an awful lot like a bunch of “mutual funds in drag” but with a higher cost structure.

In addition, there were closed end funds, which are just publicly traded mutual funds that raise a fixed amount of capital through an IPO whose shares then trade as a stock on a listed exchange. Closed end funds, however, carry commissions and fees that equate to as much as 7% percent of the initial Net Asset Value, which means that the investor paying the IPO price was left with about 93% of their money at work on day one.

On top of the 7% in fees, the funds were often leveraged by 50% in order to enhance the yield via sales of Auction Rate Preferred Stock [ARS], the very same vehicle that stranded so many investors earlier this year, and the same vehicle that so many brokerage firms ended up settling lawsuits on for vast amounts of money. We commented on this back in February in The Ugly Side of an ARS.

Way back in June of last year I highlighted the structure of closed end funds and the dangers that lurked in The Anatomy of a Closed End Bond Fund. Now that these dangers have exposed themselves and the prices have gone through a massive correction, we are finding many opportunities as we begin to buy a few select closed end funds that trade at as much as 40 percent discount to NAV. We may be early, but buying distressed assets at huge yields and at huge discounts to NAV is my cup of tea.

So I suppose one might say that I am slowly becoming more bullish in very specific areas and that this is a matter of price … that because we have the cash when others sell more out of fear, rather than due to a rational investment decision.

In summary, we can trace the lineage of this greed back much further than sub-prime in our lifetime, and even though it wasn’t the beginning of this deadly sin known as greed, the brokerage industry helped get us to the point we find ourselves in now. The traditional revenue streams dried up and yields dropped far enough to entice both individual and institutional investors to stretch for yield, ignore prudence, and succumb to ever-greater amounts of greed.

Click here for Bennet’s full report.

* President of Atlantic Advisors Asset Management, Bennet Sedacca brings with him more than 26 years of securities industry experience. From 1981 to 1997 he worked for several major investment banks, specializing in high-grade fixed-income securities marketing, trading and portfolio management. While working for PaineWebber as a Senior Vice- president, Bennet was a member of the Chairman’s Council for four consecutive years. During his years with Salomon Smith Barney as a Vice-president, he established an institutional fixed income presence in Central Florida.

In 1997, Bennet formed Sedacca Capital Management focusing on portfolio management for high net worth individuals and small to mid-sized institutions. He is also a contributor to the financial website, www.minyanville.com and is regularly quoted in Wall Street Journal Online, Barron’s and Bloomberg.

Bennet graduated from Rutgers University in 1982 with a degree in Economics and was a member of the International Honor Society of Economics.

 

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This article has 4 comments:

  •  
    Oct 15 09:55 AM
    "“How on Earth did we get into this mess in the first place?” The answer, plain and simple, is greed."

    You forgot political corruption...

    The roots of this mess have 3 names attached: Bill Clinton, Robert Reuben and PHill Gramm.

    The repeal of the Glass Act in 1999 and ceremoniously signed by Clinton is where this started.

    Wall Street purchased our Government which dutifully passed the laws to meet the demands of their owners.

    If you want to understand the Glass Act and why it's repeal is at the root of this mess, do some research on the subject. By the time you're done, you understand that (D)Clinton and (R)Gramm sold us out to Wall Street.

    There were plenty of opportunities to stop the madness, but the corruption of both parties runs too deep for common sense and the thought of our well being to take precedence.

    ----------------------...

    The "solutions" are coming from the people that caused the problem and amount to nothing more than making sure they get a refund on their loss.

    The likely outcome will be a serious devaluation of the US dollar and a crushing wave of inflation through our economy and our worthless dollars struggle to buy everything that's imported.

    This isn't going to end well folks...
    Reply
  •  
    Oct 16 11:42 AM
    not enough jails to hold all the crooks.i know a lady that was booking talent for birthday parties(clowns,Magicia... etc)who became a mortgage broker.no license,no tests,no nothing.one minute booking clowns,the next advising & arranging mortgages into the $100,000s.great oversight by the clowns in power.LOL.
    Reply
  •  
    Oct 16 12:59 PM
    Great article. I have to agree that greed is the answer. Like John stated, it links back to government, but this includes local and state governments. The entities could have stopped the massive amounts of construction, but they saw a huge increase in taxes. So, the local/state governments want the cash. Now, it seems everyone is forgetting that the 50 states and local governments are going to be paying the biggest price. Their revenues aren't going to be going up anytime soon, but their expenses are jumping through the roof with a larger population....
    Reply
  •  
    Oct 16 01:52 PM
    How do you know the assets that are the NAV all have value that will not be written down to lesser values? So how can you make a statement like you did?
    Reply
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