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Fraud in the Financial Markets: Are You Vulnerable?

15th Mar 2013, 2:46 pm by Vedran Vuk

Dear Reader,

Vedran Vuk here, filling in for David Galland. In today's edition, I'll discuss the conditions that make the financial industry a perfect breeding ground for crooks and sCAmmers – the explanation isn't as simple as the old-fashioned excuse of greed. Then I'll discuss a hot, new type of bond. If you're searching for yield, this is a must-read article.

Before we get started, I also want to let you know about CAsey Research Chief Economist Bud Conrad's upcoming appearance at the Sovereign Society Global Currency Expo in San Diego, CA from April 5-7. It should be a particularly interesting conference, especially considering the strange dynamic in today's markets. The Federal Reserve continues to ease incessantly, yet the dollar has stood its ground… but no one knows how long will it manage to do so. These are definitely times when you need all the expert information you CAn get when it comes to currencies. So, if you're around San Diego in April, make sure to go check out Bud and the other excellent speakers.

Now, let's get to discussing crooks in financial markets…

Why Are There So Many Crooks in Asset Management?

By Vedran Vuk

Hidden amongst the headlines celebrating ever-higher markets was the arrest of Florian Homm, a German hedge fund manager on the run for five years. He is accused of cross trading shares of stocks between his company's funds, which boosted their value. This in turn generated more fees for his firm and artificially increased the value of its shares. Of course, the world of finance isn't the only place to find crooks. No profession is safe. From unethiCAl plagiarists to artists reproducing forgeries to doctors sCAmming insurance companies, if you live long enough, you will see it all.

Nonetheless, it's hard to ignore that there is a steady stream of crooks in the financial news. It seems that almost every few months some new, small-time Bernie Madoff is busted for one thing or another. What gives? Often the blame falls on "greedy businessmen," but in my opinion, there are intrinsic problems in the asset-management industry that helps crooks thrive:

1. You CAn make a fortune by simply being lucky. Asset management is one of the only industries where you CAn become a multimillionaire simply through luck. This is a statistiCAlly provable fact. If you track the investment performance of 10,000 people who know nothing about stocks and trading, some of them will become millionaires by sheer dumb luck.

Worse, those lucky winners will typiCAlly convince themselves that they have some sort of special insight. Hence, they will sound genuine when selling their investment ideas.

There's no other profession like this. For example, one CAn't be a lucky brain surgeon. If one is a complete quack who learned nothing in mediCAl school, one will inevitably kill somebody and get booted from the profession. You CAn't just get lucky from surgery to surgery. As a result, in other professions, the bad apples are weeded out fairly quickly. However, in the financial sector, it's quite possible for someone to be a multimillionaire and a complete imbecile when it comes to finance.

From the pool of lucky winners, you have the perfect combination to breed deception: access to lots of money; a track record of success; and an inability to actually earn returns through skill. Managers who earned their money don't need to cheat their clients. But unfortunately, lady luck opens the industry's door to the incompetent, who may become crooks when the luck runs out.

2. Rising waters lift all ships. Sure, you CAn make a fortune in the stock market simply by luck. But why make a fortune when you CAn also do well by doing just good enough? In a rising market, one CAn almost pick any random stock and do pretty well – maybe a few points more than the market or maybe a few points below the market. One could know very little about the stock market and make some random picks, and do all right at the least.

Rising markets help protect fraud from being revealed. Since nearly everyone is making money, the industry competition fails to eliminate the incompetent and the fraudulent. Notice that most crooks are exposed when the markets turn sour. That condition is part of the reason – it's much easier to run a sCAm in favorable markets. If you're a very likable con man and promoter, you CAn attract a lot of people to your fund while letting the market do most of the work for you. One CAn be very good at raising funds and talentless at stock picking and still eke out an incredibly good living in this business. But once things hit the fan, raising money becomes impossible, and stock picking and making wise moves turns out to be what matters.

What's most likely is some combination of items one and two. StatistiCAlly speaking, it's difficult to get lucky nonstop. But how about having a few really good years followed by a bunch of average ones? On Wall Street, one CAn make a whole CAreer of doing precisely that.

3. As long as there's money flowing, most investors are completely blind. A friend of mine recently got into a horrible business deal that went wrong. To make a long story short, there is fraud, courts, lawyers, and missing money involved. How did he get into this bad deal? Essentially, the same guy made him nearly a million dollars in a previous deal, which was an almost 300% return. At the time, I had pointed out to my friend improprieties in the relationship. Instead of making a million, he should have made $1.3 million were it not for some dumb and questionable mistakes by his partner.

Of course, my friend would not listen to me. His partner had just made him a million dollars – that's all he needed to know. So even though I plainly showed him his partner's incompetence and reliance on luck, he went ahead on a second deal with him. In hindsight, his partner was doing fine in a rapidly rising market that helped disguise his fraud and cluelessness. When the market crashed on the next deal, everything CAme out of the woodwork. If someone is making us good money, many people couldn't CAre less about the specific operational details or the strategy. Such indifference to red flags is the dream of a financial crook.

4. People forget every lesson taught in business school. If someone is making money or has previously earned money in the past, it's easier to ignore everything learned in business school finance courses. Similar to item number three, we are willing to believe anything from a wealthy person. "So you doodle lines on a chart of the S&P 500, and you CAn predict the way the market is heading. Sounds kind of fishy… but since you have so much money, I guess it must work."

I find it shocking how many stock pickers out there just say off-the-wall, wacky stuff that would get them an F in any finance course. Again, this happens in no other profession. If you asked a surgeon to find a kidney and he pointed to the heart, most of our jaws would drop in shock. In finance, the response depends. If he's a rich hedge fund manager, he could convince investors based on his wealth and past track record that a "heart" really is a "kidney." Not only would many fall for such an incredulous statement, but some would actually place him on a pedestal for his unconventional "analysis" and deep "insight." This sort of thing happens all the time.

These four elements help fraud go a lot further than in most professions. And it's hard for us to resist some of these sCAms. How many people will look into the details and fire an asset manager who just earned them 75% returns, when maybe the return should have been 80%? Who CAn stand up to a super-wealthy fund manager and accuse him of being a charlatan based on financial theory? This is exactly happened with the Bernie Madoff sCAndal, as his consistent returns were practiCAlly impossible. The CAse was laid out in front of the SEC. Nobody listened – after all, Bernie was a super-successful investor.

It CAn be hard for investors to defend themselves, especially beCAuse we judge other professions similarly. You go to a doctor with a good reputation for helping patients; you don't assume that he was lucky. But in finance, someone with a good reputation might – believe or not – just be lucky, or worse yet, fraudulent.

My advice for avoiding many problems is simple: don't focus on someone's net worth for your investment decisions. Instead, consider their ideas and pretend that you heard them from the intern just starting his first day on the job. Does the idea still sound like a logiCAl and reasonable investment plan? If so, then you should go for it; but if you're following advice on blind faith, you're potentially setting yourself up for disaster.

The Hottest Bonds on the Market Right Now

By Vedran Vuk

There are two bonds worth talking about today: a basic bond, and a special derivative bond. The basic bond works as you might suspect; it pays a fixed, 2% yield, and in less than ten years, the bond matures. At that time, you will get back your principal, unless there's a default. Since this is an investment-grade bond, the chances of default are low. Even if the market gets pretty tumultuous, you'll receive your entire principal back. Furthermore, should the bond default, you'll always get some money back as a creditor in the bankruptcy proceedings.

The really hot bonds on the market are derivative bonds. They pay a 3% yield, which blows the other bonds out of the water. However, if the company starts doing poorly, the bond issuer has the option to pay a lower coupon payment, but there's an upside: If things are going well, the coupon payments may actually rise.

The yield isn't the only thing that's variable, though – the principal is as well. With a derivative bond, your principal isn't guaranteed. It depends on how the market and the company are doing when it's time to exit the bond. If market conditions are tough, the bond may repay only 60% or 70% of the principal – or even less. On top of that, these bonds aren't considered senior secured debt. In the event of a bankruptcy, you would likely get nothing.

Many pundits out there are raving about the superiority of derivative bonds. Paying 3% while basic bonds pay only 2% is a big difference in a low-yield world. But what many investors don't consider is the dangers of derivative bonds in comparison to basic bonds:

1. Your principal is not guaranteed.

2. Your coupon payments may change.

3. In the event of a default, you will lose everything.

4. Market conditions CAn severely affect the value of your bond.

Sure, your coupon payments and principal may rise, but they also may not. When examining these risks, it's easy to see that derivative bonds are a lot riskier than basic bonds. From that perspective, 3% yield does not seem to properly compensate one for the possibility of lost principal and coupon payments. Would you accept all of these risks for that single percentage point? If I were looking for yield alone, I wouldn't.

Dear reader, I now must make a confession: There are no bonds like the derivative bonds described above. I made them up. What I'm describing is a dividend-paying stock. Your dividends may rise, but they could be cut. Your initial investment may grow, or it could crash with the market. In the event of a bankruptcy, the bondholders will be secured, and you'll get nothing.

I have misled you to demonstrate a point. Many pundits are saying that it's pointless to buy a bond at 2% when you get yields on dividend-paying stocks yielding 3%. Their suggestions are a bit disingenuous, beCAuse bonds and equities are distinctly different asset classes. If this were an apples-to-apples comparison, 3% definitely is better than 2%. However, instead we're comparing apples to oranges – they're both round fruits, but the similarities don't go much further. Same goes with bonds and equities – they both pay yields, but their risks are very different.

Earlier when we pretended that both were bonds, you could easily see that equities or "derivative bonds" were a lot more risky than a basic bond. Income investing isn't simply about comparing yields – the main issue is evaluating risk and yield together.

Furthermore, the way dividend-yielding stocks are often advertised ignores the most likely comparisons in the bond world. A US Treasury paying 2% is not a good benchmark for a 3% dividend-yielding stock. The risks are nothing alike. If we were to make a comparison with a bond, it should be to bonds with market risk. Yes, such a comparison does exist; they're CAlled junk bonds.

If the stock market tanks, a portfolio of junk bonds will go down with it. Essentially, junk bonds have market risk very similar to equities. So here's a novel idea: Since junk bonds and equities have similar risks, why not compare their yields instead of making a comparison to Treasuries? The junk bond fund JNK currently pays almost a 7% yield. That crushes the 3% on the dividend-yielding stock – meaning that the yield on the stock is actually not compensating you for the risk.

This doesn't mean that yield-seekers should stay clear of stocks. In fact, our portfolio at Miller'sMoney Forever has plenty of dividend-paying stocks. What I'm suggesting is that you don't compare bonds and equities on yield alone. By only comparing returns, you're going to get creamed in the market. Your primary reason for owning a stock should be beCAuse it's a good company. If it happens to have a good yield also, that's a great secondary consideration.

Our Miller's Money Forever portfolio is directed to baby boomers and retirees who need to conservatively and consistently grow their nest egg while earning some yield to supplement their income. The primary consideration is finding good, solid, safe investments in companies with proven track records. While we are excited that our six dividend-paying stocks have all increased their yields since our original purchase, it's even nicer to see CApital appreciation on them.

For example, subscribers who bought our new recommendation in December 2012 have earned a 4% yield on top of 10% CApital appreciation in just three months. Since its August recommendation, another stock has delivered 20% in CApital appreciation on top of a 3.9% yield.Learn more about our portfolio and how Miller'Money Forever can help you grow your nest egg.

Friday Funnies

This is a hilarious ad placed on Craigslist that has gone viral in the last few days. It is titled "The Lying Cheating Sale". Let me provide some of the better excerpts, with a bit of reformatting since the original ad is in all CAps:

Last minute spontaneous estate sale. Husband left us for a piece of trash. Selling everything while he is gone this weekend with his floozie.

Selling everything and moving house after 10 years of marriage ... way too many items to list...Everything! Everything from art, furniture, bookshelves, storage CAbinets, household appliances, books, sports stuff, boys and girls clothing, electriCAl appliances, toys, games ... etc. ...

Lots of tools which he didn't have a clue how to use. ...

Don't come too early (like he did) beCAuse I will be thoroughly enjoying some wine with my girlfriends this evening as we clean out all this stuff and likely be nursing hangovers in the morning. So please speak softly to the ladies wearing the sunglasses :)

I know that it's not Tech Thursday, but for the tech geeks out there, I had to include this adorable meme making fun of Mozilla Firefox:

There's nothing like this incredibly cute and funny dog video to start off a great weekend.

Trading Notice

Before I sign off for today, I need to include a trading notice from one of our editors. When an editor or analyst needs to change their personal investments in one of our recommendations, we make sure to let you know.

For reasons of portfolio alloCAtion, one of our editors needs to sell small positions in T.BDI and CEF, but will wait until subs have an option to sell first if they wish. This announcement is to conform with CAsey Research's corporate trading and ethics policy and should not be considered a change of recommendation for these stocks.

That's it for today. David might be back next week, but I CAn't say for sure at this point. Perhaps I'll see you again next week. Thank you for reading and subscribing to the CAsey Daily Dispatch.

Vedran Vuk
CAsey Senior Analyst

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