Wall Street’s Sub-Prime Meltdown Is A Wake-Up Call For Main Street Investors

The recent sell-off in global equity markets, the Federal Reserve’s rate cuts, Washington’s emergency stimulus  plan, and same-day 500+ point swings on Wall Street, have many investors asking, “Why does the sub-prime mortgage market  impact me when I did not buy investment property in   Florida and I don’t own shares in a hedge fund?” The answers can be  confusing, but part of the problem might also be down the street in your broker’s office — and not just on Wall Street.

In very simple terms, the link between the sub-prime mortgage market and the stock market is this: Non-traditional lenders, using artificially cheap money from the capital markets, made creative loans to higher credit risk, “sub-prime” borrowers. For a time, this fueled a rise in real estate  prices. Wall  Street investment bankers bought these loans, bundled them  together into high yielding asset-backed securities, and then sold them mostly to institutional investors like mutual funds, hedge funds, insurance companies, and pension funds. Everyone along the supply chain, including loan originators, brokers, lenders, investment bankers, attorneys, rating agencies, insurance companies, and institutional buyers, made a lot of money and everyone was happy. Then, as the cheap mortgage money industry began to hiccup last spring with the bankruptcy of several sub-prime lenders, tighter credit standards made it harder for borrowers to stretch to buy bigger homes or investment  properties, housing demand slowed, values and prices began to fall, borrowers began to default on the front end, and institutions discovered they could not value their investments on the back end. General economic growth began to slow and inflation spiked, leading the economy to the edge of what  many believe to be a near — if not certain — recession. Any shock to the financial system stirs sellers in the   securities markets, and this chain reaction is a whopper.

The write-down of asset-backed securities approaches $200 billion domestically, and some estimate it could be as much as $500 billion internationally. The ensuing credit crunch, housing-related declines, global economic uncertainty, and rising inflation, have set the stage where the uncomfortable market volatility has advanced into outright panic selling.

Clearly, it is not just institutional investors on Wall Street who are suffering. Middle and working class investors with good credit records, who budget and spend within  their means, and who save diligently for retirement, are now feeling real pain, and to some extent fear. For many average investors, memories of the 2000-2003 bear market, when the S&P 500 was down 49%, are still fresh. The swiftness of this market decline has caught many off guard.

The average investor is likely to have an employee benefit account (e.g., a profit sharing or 401(k) plan); a professionally managed investment account, or a non-discretionary individual brokerage account. The actual investment decision maker might be a statutory fiduciary (think ERISA), a registered investment advisor, a fee-based or asset-based planner or financial consultant, or perhaps a traditional stockbroker who is paid on commission. The legal question of whether a decision-maker has violated a professional duty is fluid and very fact-specific. However, there are some general principles to begin the analysis.

For fiduciary investors (anyone with discretionary authority over investment selection, e.g., the trustees of an employee benefit plan or governmental retirement plans, trust accounts, and paid investment consultants), the key question is whether plan assets were prudently diversified. Investment fiduciaries are judged not on investment performance, but by whether investment decisions followed a defined and prudent process and were properly documented. For example, with respect to employee benefit plans, trust accounts, and managed individual investment accounts, there should be a written investment policy statement and a disciplined process to select investments diversified across asset class and market sectors to minimize risk, monitor performance, and make adjustments as necessary. For managed investment accounts where the broker, financial advisor, or investment manager are paid to select the investments, the analysis is much the same.

A fiduciary is obligated to diversify plan assets, which is not necessarily the same as asset allocation. Asset allocation addresses the distribution of assets among various investment classes to yield the greatest possible return consist with a portfolio’s risk profile. Diversification is a risk-reduction process of choosing a broad range of different individual investments within a particular investment class.

For individual investors with traditional non-discretionary brokerage accounts, the analysis is somewhat different. The main question is whether a broker’s investment recommendations suitably fit within the investor’s financial objectives and risk tolerances. This is a highly fact-specific analysis, which is often challenged by the broker’s argument that the customers received confirmation and monthly statements and then didn’t complain until the account value declined. Therefore, according to the broker, the investors must have agreed that the selections were consistent with their objectives and risk tolerances. The more likely fact is that the average investor does not   understand the distinctions between discretionary and non-discretionary accounts, asset classes, portfolio theory, and the myriad of securities and issuers and therefore likely relies entirely on the broker and the advertised expertise and resources of his employer.

Whether a fiduciary or non-discretionary brokerage account, all investors are entitled by law to various minimum standards of professional care and conduct. Many professionals will immediately defend any account loss by rationalizing that all markets go up and down. While obviously true, there are minimum legal standards that apply regardless of market gyrations and, as recent events illustrate, the consequences of not asking the right questions may simply be too severe to ignore.

Mr. Flynn represents individual and institutional investors, financial professionals, and businesses in investment-related matters and other business disputes. He is a member of the Ohio, Kentucky, and Federal Bars and a charter member of the Public Investor Arbitration Bar Association (PIABA), a national association of attorneys committed to representing investors in disputes with brokers or other financial advisors. Please contact Mr. Flynn at (513) 629-9412.