There's a new recognition that not all big investors are savvy enough to play the swaps game
What is a sophisticated investor? According to securities laws, the more money you have, the more knowledgeable you must be, and the better able to look out for your own interests. That's why individuals with a net worth of $1 million or more can make investments that are off-limits to people with less money. Institutions that manage $100 million or more are considered to need the least protection—whether they are small city governments trying to pay for sewers or huge investment companies such as BlackRock (BLK). Now, Wall Street's biggest firms are debating whether to change the way they sell opaque financial products like interest-rate swaps to governments, endowments, and not-for-profit institutions, according to executives at four Wall Street firms who spoke on condition of anonymity because their companies haven't made any decisions.
"There is no distinction among very different groups of investors, and this is where things might change," says Dino Kos, managing director at Portales Partners 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." The changes would "at least initially" reduce earnings because "it would be harder to sell higher-margin products to some customers," says Kos.
The Wall Street soul-searching was triggered in part by the Securities & Exchange Commission lawsuit against Goldman Sachs (GS) for allegedly failing to inform a German state bank and New York-based collateral manager ACA Management about the role of hedge fund Paulson & Co. in a mortgage-linked security. Goldman Sachs executives have said that the firm did everything the law required. Chief Executive Officer Lloyd C. Blankfein 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 its business standards committee will review practices including "the suitability of products for different types of clients."
While the definition of sophisticated hasn't changed in decades, Wall Street has been selling increasingly complicated products, such as auction-rate securities, collateralized debt obligations, and swaps, which are often used by borrowers with floating-rate debt to lock in rates. Swaps soured for local governments, including those in Jefferson County, Ala., and hill towns in the Umbria region of Italy. JPMorgan Chase (JPM), without admitting or denying wrongdoing, agreed to a settlement with the SEC in November that ended an investigation of the bank's derivatives sales to Jefferson County.
Pennsylvania Auditor General Jack Wagner has asked the state's lawmakers to repeal 2003 legislation that allowed school districts and local governments to enter into swaps, which he said was "tantamount to gambling with taxpayer money." In April he said the state's turnpike commission would lose $145.7 million if it had to terminate its swaps contracts on more than $2.2 billion in debt.
Harvard University used $467.6 million from a bond sale in December 2008 to break free from $1.1 billion of interest-rate swaps and separately agreed to pay $425 million over 40 years to reverse $764 million of swaps.
Securities laws differentiate between investment advisers, who have a "fiduciary duty" to their clients, and brokers, who must only determine whether an investment is "suitable." The fiduciary duty obliges advisers to put clients' interests ahead of their own; the suitability standard entails ascertaining whether customers are able to understand and withstand the risks.
The financial reform bill that the Senate passed last month attempts to address sales of swaps. The legislation, which needs to be reconciled with a version passed by the House in December, would require swaps dealers to adopt a fiduciary duty in dealings with state or local governments, endowments, and pension and retirement plans.
Although the measure is designed to protect taxpayers, it has been opposed by state treasurers. In a May 16 letter to Chris Dodd, the Connecticut Democrat who chairs the Senate Banking Committee, the National Association of State Treasurers said that suitability requirements, not fiduciary duty, should apply to dealers.
Utah State Treasurer Richard K. Ellis says he avoids using swaps to manage the state's debt because he thinks the risks outweigh the rewards. "We've been pitched on interest-rate swaps as long as I can remember," says Ellis, who served as deputy treasurer for nine years before becoming state 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."
The bottom line: Wall Street may cut back on a lucrative practice: selling complex products to big investors who don't necessarily understand them.