Who’s left holding the bag?
Posted: September 13th, 2011
This guest post is written by Gurpreet Banwait who is the director of Insight Solutions Product Management at FINCAD.
It seems every few years a new scandal is uncovered where information provided by a company is found to be fraudulent and investors are left wondering where their money has gone. We’ve certainly seen a number of Ponzi schemes over the years, and when you see the list on Wikipedia it’s actually rather frightening. While Madoff’s case was one of the more famous ones, the list is long and it seems that there is always some other company finding a new and innovative way to separate a fool from his money.
When people start pointing the finger at a company that has perpetrated a massive fraud, the usual defences kick in as we hear the company proclaim their innocence in press releases and analysts still saying there is nothing wrong and investors should continue to buy. Ultimately, the truth comes out and, not to our surprise, the company really did commit fraud.
In some cases, the fraud continues as principals of firms are selling their shares or advising close acquaintances to not buy or even to short sell the company’s shares. These individuals will then profit as the share price inevitably falls.
So what’s my point with this story? It continues to amaze me that with this many smart people involved with the company, whether it’s lending the company money, providing their recommendations or auditing the company’s financial statements, that if they can’t see through this potential fraud, what chance does an investor have? Typically, there are both small and large investors that lose their money, but the ones most hurt will be the smaller investors who thought this company was a safe bet based on the recommendations and following by much larger investors. I know that some will say that this is the risk of the financial markets, but just think how many so-called experts lost money, lent money or gave their opinion on these companies.
Who is left holding the bag in this mess?
I co-founded
At the base of the problem is information (which, of course, is one of your points!). Larger investors can spend more time and money vetting their investments, but (as you point out) they can get fooled, too. I would add to this that you cannot neglect the cases where large investors don’t properly vet their investments, and where government regulators give (typically small) investors a false sense of security, both of which helped cause the 2008 financial crisis in the states.
The former case should be punished by allowing the investors (large and small) to go bankrupt, and the latter case should be punished by regulatory reform. Sadly, in the States, it seems that neither course was taken: large investors were rewarded by multi-billion dollar government bailouts, and regulatory reform doesn’t seem to have changed the US markets for the better. Of course, this course of action ultimately leaves the taxpayers holding the bag, in terms of lost investments, higher taxes (eg, the push to increase the capital gains tax in the US), and in terms of lost GDP (the US lost ten years of growth).
The same thing is currently happening in Europe, who seems to have learned very little from 2008. Substitute “high risk mortgage” for “Greek sovereign debt”, and substitute “SocGen” for “Goldman”, and the story is unchanged. German tax payers are now subsidizing poor decisions by French and German banks to lend money to risky investors at a rate which didn’t truly reflect their risk. The answer from the EU is to spend more German taxpayer money stabilizing bond markets, which doesn’t seem any more fair now than it did in 2008, when the US did the same thing for its big banks.
As an aside, these Ponzi-type schemes tend to be illiquid investments. I haven’t been able to think about a good way to quantify “information risk”, but a good proxy may be liquidity risk—every time an asset is bought or sold, the buyer and seller are expressing opinions about its value. Thus, as an investor, I think, the liquidity of your portfolio should match its notional—the best advice I’ve heard about investing comes from Warren Buffet: “I don’t invest in things I don’t know about.”
I feel obliged to correct myself here.
I was listening to Bloomberg yesterday morning on the way to work, and one of the guests pointed out that one salient difference between Europe in 2011 and the US in 2008 is that liquidity in the inter-bank market hasn’t dried up. Indeed, today the WSJ tells me that the Fed, Bank of Switzerland, Bank of Japan, and the Bank of England have all offered to inject dollar liquidity into the European markets.