Just a quick observation- Flipping through CNBC and Bloomberg this week and perusing through the Wall Street Journal, it seems the financial crisis is no longer “leading news” material. The health care debate has taken the mantle.

In a recent article, Is Your Fund Pawning Shares at Your Expense?, Wall Street Journal columnist Jason Zweig takes a look at securities lending practices among various mutual funds and finds, in some cases, cause for concern. “Securities lending is sensible and beneficial in the right hands,” he observes, “but can wreak havoc when it is done wrong.” Last year’s turbulent fixed income market led to problems in unexpected places such as money market funds or short-term “enhanced cash” strategies, and a number of lending programs experienced losses associated with reinvestment of collateral backing the securities on loan.

Zweig’s principal gripe is that some fund sponsors keep a portion of the lending revenue even though loaned securities belong to fund shareholders and they bear the risk associated with such activities. He notes approvingly that T. Rowe Price Group and Vanguard Group “rebate all securities-lending income (net of expenses) back to the funds that generated it.” Although not mentioned in the article, Dimensional funds likewise receive 100% of any net lending revenue.

Zweig’s article suggests that fund investors and their advisors should pay close attention to securities lending practices, the allocation of revenue, and the financial incentives for those providing lending services to the fund.

A description of Dimensional securities lending practices appears on page 80 of the DFA IDG/DIG prospectus dated February 28, 2009, and a related risk discussion appears on page 16. A table on page 36 shows net lending revenue for the fiscal year ending October 31, 2008 for twenty-seven funds, with the funds earning a total of $182,252,000. The resulting performance enhancement among these twenty-seven funds for the fiscal year ranged from 0.04% for US Large Company Portfolio to 0.66% for Japanese Small Company Portfolio.

Karmin, Craig. “Securities Lending is Being Squeezed.” Wall Street Journal, October 1, 2008.
Zweig, Jason. “Is Your Fund Pawning Shares at Your Expense?” Wall Street Journal, May 30, 2009.

Although we can only guess at the direction of the upcoming market, we can all be pretty certain that Wall Street’s pitch from their army of brokers will be safety. Investors will be presented with a plethora of structured investment products that will theoretically provide profits and limit losses. Where do I sign up?

An article in this week’s Wall Street Journal, Twice Shy on Structured Products, states as much. Still ringing from the 2008 stock market, selling safety to potential investors is easy. The problem is that what is easy is not necessarily appropriate. Investment advice should not be “sold.” It should be based on need. And if the recent events have any learning experiences, it is that incentives need to be aligned with outcomes and not with short-term compensatory opportunities.

Structured products if misused can easily cash in on investors’ short memories by pushing these high-fee products with safety as the big selling point.

As the article points out:

“Brokers are eager to sell these structured products because commissions are high, but they face explaining why many of these products didn’t perform as advertised. They also must convince clients that the firms behind these products are solid. Investors who bought products backed for firms that failed, such as Lehman Brothers, have big losses.”

“When Lehman Brothers Holdings Inc., which floated at least $900 million in structured products last year, filed for bankruptcy in September, investors sustained big losses. Many are hoping to recover just 20% of their investment, says John Barry, chief executive of fixed-income trading platform Bonds.com.”

I guess another lesson from this past market is that in times of extreme stress and when safety is needed the most, the words “principal” and “protection” should go together only if it is followed by the safety of U.S. Gov’t. short-term treasuries.

The recent article in the Sunday Times by Gretchen Morgenson titled “Red Flags that Muni Investors Can’t See“  provides a reason to bring out the old’ “sunlight is the best disinfectant” quote from U.S. Supreme Court Justice Louis Brandeis.

The article details the lack of transparency in the muni market between the quality of the bonds that are bought and sold to unsuspecting investors.

Points that merit attention:

1) Cities, hospitals, and states borrow money from investors through munis and are required to file basic reports outlining their conditions. Unfortunately, many fail to make such filings. Out of the 65,000 issuers of these securities:

1 in 2 is more than a year late in filing

1 in 4 is chronically delinquent, by three years or more

How would stock investors react if 1 in 4 public companies did not bother to provide an annual report and half of all companies were a year late in filing?

2) 1 in 4 issuers had issued distressed notices, an indication of significant financial problems

3)  More alarming was that many of these “distressed issues” were purchased by individual investors at par value- which means they were purchased by investors as if the underlying entity was financially health.

Of the 9,643 distressed muni sales that were sold to customers, more than half of them, 5,798, were bought at par value or higher.

41% of these purchases were made by the small investor, as indicated by the size of each trade - $50,000 or less.

Essentially, the individual investor overpaid for the distressed securities and the dealer pocketed the difference.

There is nothing inherently wrong with municipal securities. They serve an effective purpose in the economy and in one’s tax efficient portfolio. But when there is such obfuscation in simply buying and selling a security, it seems all the economic benefits can be lost to the investor and surreptitiously conveyed to the selling party.

With a 22% trading increase of municipal securities this past year, it seems many investors flocked to the safety of bonds to avoid the risk inherent in distressed positions. Based on the most recent research, many did not really receive that safety and were a victim of the Wall Street assembly line.