Sense on Cents

In the midst of all the legislative wrangling in Washington and the financial gyrations on Wall Street, what does it all mean for everyday American investors? I am not so sure it means all that much. How much are everyday Americans impacted by proprietary trading, derivatives, merged regulators? Very little actually. I am not writing this to discount the proposed financial regulatory reform coming out of Washington, but I remain underwhelmed that it will truly protect everyday investors from the ways of Wall Street.

To this end, I am happy to propose my own Sense on Cents Financial Reforms which I believe regulators should impose on financial intermediaries (brokers, bankers, money managers, et al). I am not only proposing these reforms here, but I am sharing them today with Washington based financial regulators. In deference to my readers, you’re getting the first look. Feel free to share your thoughts on my proposed reforms, and add others which you believe should be implemented.

The goals of my proposed reforms will be to create greater transparency in products offered by financial intermediaries  with an eye to achieving greater understanding of the real risks involved. To that end, I would ask those reading this commentary how often and how extensively you read and review the prospectus for a securities offering? Probably not all that often or all that extensively. Even if you do read the prospectus, do you fully understand all the risks? I am guessing not. How do we rectify this critically important shortcoming in the investment process?

Sense on Cents proposes that financial intermediaries must be required to develop and disseminate a simplified form hereby defined as Risk Parameters for each and every security offered to the public. I believe Risk Parameters should not only cover and highlight the implicit and explicit risks of each and every security offered to the public, but also assign a relative grade of 1-5 for each measure of risk. I would fully expect Wall Street to wail long and loud about providing these Risk Parameters. If regulators do not mandate them to do just that, investors can still request this info from their brokers. If you do not receive this info, then I recommend you find another broker.

What should the Risk Parameters document encompass and detail? The following:

1. Market Risks: How might this security perform in up or down markets? What market benchmark should investors utilize to measure the relative performance of this security?

2. Interest Rate Risks: How will movements in interest rates impact the value of this security?

3. Liquidity Risks: How liquid is this security? What type of secondary market should be expected in this security?

4. Volatility Risks: Will an increase in volatility positively or negatively impact the value of this security? Is there an embedded option in the security which will change in value given a change in volatility?

5. Credit Risks: What type of credit risks are involved in this security? Corporate credit risks? Individual credit risks? Sovereign credit risks? Who is evaluating and assigning these credit risks? What is the outlook for the credit risks involved in the security?

6. Currency Risks: Is there a currency risk in the security? How so? Is the currency risk hedged or not?

7. Structure Risk: Is the security part of an overall structured transaction? Where does this security fall in terms of overall subordination?

8. Counterparty Risk: Even if the security itself performs, are you put at risk if the counterparty with whom you are dealing fails to perform? (Do you think the thousands of investors with exposure to Lehman Brothers wished they had effectively considered this risk?)

9. Extension Risk: Can the return of your principal and interest take on a longer time horizon than initially thought or perceived, thus creating extension risk? How? Why? Think investors in auction-rate securities wish that they were apprised of this risk?

10. Transparency Risk: How actively traded is the security? Is the trading of the security reported on TRACE? If not, how will you be able to know what sort of typical bid-ask spread is involved in the security?

11. Competency Risk: How well versed is the broker in understanding the risks involved in the security? This is a HUGE risk and must be assessed.

Wall Street would fight this Risk Parameters document, but if they were smart they would embrace it. While this document may initially eat into revenues, I strongly believe it will lead to greater investor confidence and ultimately greater volumes.

Are you sitting there thinking that you can’t ask these questions of your brokers, or you don’t feel comfortable asking them? Oh, yes you can. In fact, you must!! Remember, the real lesson of this economic and market crisis is Caveat Emptor. Don’t wait for regulators to mandate that Wall Street implement these Risk Parameters.

If your brokers, financial planners, banks, and money mangers are neither willing nor able to provide you a significant degree of comfort on all of the above risks, why would you do business with them?

I hope you will share this Sense on Cents Financial Reform with your friends and colleagues.

LD

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This entry was posted on Friday, May 21st, 2010 at 9:05 AM and is filed under General, regulation, Wall Street. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.