Don’t do this:
One particular municipal entity had been a customer of Wells Fargo, or a predecessor, since at least 1988. This customer’s investment objectives were safety of principal and income. … Wells Fargo’s internal records for the customer’s account specifically stated that the account should not invest in MBS. In addition, applicable state law prohibited municipal entities such as this customer from investing in certain “high-risk mortgage-backed securities.”
Respondent McMurtry nevertheless selected and purchased for this municipal customer a SIV-issued asset-backed commercial paper program which was backed by MBS and related high-risk mortgage-backed derivatives. … On April 30, 2007, McMurtry selected and purchased Golden Key on behalf of the customer. McMurtry did not know what a SIV was at that time he selected Golden Key for his customer. Further, he did not read the PPM for Golden Key, nor did he inform the customer of the risks related to the SIV structure or the underlying high-risk mortgage-backed assets held by Golden Key.
Well, I mean, in his defense it seems that McMurtry had a very good excuse for not informing the customer of the risks of Golden Key, specifically that that he didn’t know what those risks were, or what Golden Key was, or presumably where he was or how he got there or how many fingers the customer was holding up.
The world is safe from Shawn McMurtry for the next six months, since he and his employer entered into a settlement with the SEC today suspending him and fining Wells $6.5 million for its unconcern with the fact that its salesmen were not particularly interested in doing their jobs and/or illiterate:
Among other things, Wells Fargo and its registered representatives did not review the commercial paper private placement memoranda (“PPMs”) for the investments and the extensive risk disclosures in those documents. Instead, Wells Fargo and its registered representatives relied almost exclusively on the credit ratings of these products, despite warnings against such over-reliance on ratings. Wells Fargo also failed to establish any procedures to ensure that its personnel adequately reviewed and understood the nature and risks of these commercial paper programs.
The SEC’s complaint is funny and it’s pretty clear that the Wells Fargo brokers selling this stuff were goons. Actually you don’t need to read about what they did to know they were goons; this tells you a lot:
Approximately ten Wells Fargo customers were holding a total of approximately $104.4 million in commercial paper issued by Mainsail, Golden Key and Rhinebridge when the defaults occurred. … Wells Fargo’s total commission in 2007 for the sale of Mainsail, Golden Key and Rhinebridge was approximately $65,000.*
So they got paid 6.2 basis points for placing $104mm of paper. There are lots of very very smart people on Wall Street who work for 6 basis points, but I submit to you that few of those people actually read private placement memos. (Many of those people are actually robots.) You get what you pay for, and salesmanship-wise six basis points will just pay for a hearty handshake and a “how’re the kids?” Reading the private placement memo is way, way extra.
Will that change now? Sure, sort of. Wells has fixed its sales practices to better handle asset-backed commercial paper, so that now when Wells Fargo sells you asset-backed commercial paper there will be at least a reasonable likelihood that someone at Wells Fargo, possibly the guy selling it to you, has looked at the disclosure for that paper, or at the very least has told you where you can look at the disclosure for that paper.**
It is less clear that these modest improvements apply to non-asset-backed commercial paper, which is of interest in part because of this:
But also because of two good things recently written about securitizations and related stuff – this St. Louis Fed piece that provides a nice overview shadow banking, and this paper by William Bratton and Adam Levitin that is a little hard to summarize but it’s basically (1) a history of some securitization-related-scandals and (2) an argument that securitizations are the apotheosis of the “nexus of contracts” theory of the firm and that law trails behind accounting in finding useful ways to put that in its pipe and smoke it. Here is a favorite quote from the St. Louis Fed:
Finally, and contrary to popular belief, this form of banking increases transparency and disclosure because banks now sell assets that would otherwise be hosted on their opaque balance sheets.
And from Bratton & Levitin:
And, despite the transactional complexity, the product brought forth [in a synthetic CDO or other structured product] is relatively simple when compared to debt securities issued by conventional operating companies. Even though the conventional operating company’s debt can be issued pursuant to a much simpler contract, market’s overall analysis will have to grapple with the factual complexity of the company and its business; there will be inevitable opaque patches in its profile. Accordingly, the bank that markets the conventional debt product will have to invest in disclosure so as ameliorate information asymmetries. Potential purchasers will have to invest in research and then go on to evaluate the notes against the yardstick of their existing portfolios; the notes may or may not fit.
A synthetic [read really "structured product"], in contrast, is completely transparent — the assets are there on a list for all to see, each rated by a credit rating agency. The autopilot contractual instructions for the SPE eliminate most operational risk.
These are things that I have often thought, particularly in reference to the abysmal performance of rating agencies in rating structured products: structured credit products are not that hard! They’re hard, sure, in some absolute sense, but they’re not harder than banks. Banks are like structured credit products only, instead of owning a bunch of securities that you can see on a list and think about and decide whether you like them, they own a bunch of securities whose identity is kept secret and whose composition can change every day through the actions of, y’know, Shawn McMurtry.
If you think it’s a bad thing that various municipalities got singed when a bunch of overlevered investments in subprime securities blew up – and you do, right? what are you, a monster? – then where do you place the blame? The municipalities? I mean, sure, absolutely, they were dopes, but their job was to be dopes – they thought they could rely on layers and layers of paid advisors who seemed to owe them something. The people who built the SIVs? Yes, they were clearly arbitraging the inattention of various other parties in order to maximize profits, so, bad on them, except: they were traders, and arbitraging others’ inattention (within antifraud rules, etc.) was their job. The rating agencies? Absolutely: they were dopes too, but their job was not to be dopes, so bad work – but bad work protected by the First Amendment.
Brokers who put unsophisticated customers into these trades are a good target: unlike structurers and raters who can hide behind legal disclosure, the brokers’ job was actually to find suitable investments, so it’s fair enough for them to get in trouble when they didn’t even try to do that. So good work on the SEC for fining them – and for fining them an amount that, while pretty small, is still 100x what they made on selling this paper.
Still, it’s a little unsatisfying, because while these brokers were a weak link they’re also not a really reparable link: “suitable” is actually a pretty low standard, and while you can regulate minimum competence for these brokers – you can make them read the PPM – you can’t make them read it critically, and you certainly can’t make them make the right decisions for their clients. Six basis points certainly doesn’t buy the right decision.
If the Wells salespeople here had read the “approximately 20-30 pages of risk disclosures” that the SEC found in the private placement memos for these bad SIVs, what would they have done about it? I dunno, maybe they’d have told their clients to invest in more traditional commercial paper, like that issued by Wells Fargo. WFC’s annual report risk factors only run 15 pages, and it’s just about imaginable that they would’ve replaced their “just pick the highest yield at a given rating” heuristic with “just pick the highest yield at a given number of pages of risk factors.” Or something else. More likely, they’d have read the disclosure, nodded gravely, realized that (1) these things were complicated but (2) people at a ratings agency who were actually paid to examine their creditworthiness had rated them A-1/P-1 and (3) they had a higher yield than similarly rated non-complicated things. Perhaps the Wells Fargo municipal-client commercial paper sales desk would have been in the minority of people who saw the storm coming in subprime securitizations and would have saved their clients from investing in them. But, no.
SEC Charges Wells Fargo for Selling Complex Investments Without Disclosing Risks [SEC, and complaint (pdf)]
Bratton & Levitin: A Transactional Genealogy of Scandal: from Michael Milken to Enron to Goldman Sachs [SSRN]
Is Shadow Banking Really Banking? [St. Louis Fed]
* Before you’re all “yeah, but what did they make in 2006?,” those SIVS came on the market in 2007.
** From the complaint again: “The steps include: (1) a Wells Fargo Asset-Backed Commercial Paper Permitted List wherein the offering documents for asset-backed commercial paper are reviewed by money market traders and a limited number of commercial paper products are permitted for sale to institutional customers; (2) enhanced supervisory procedures related to the assessment of product knowledge by registered representatives in the relevant designated sales force who sell commercial paper to municipalities; (3) quarterly meetings attended by the heads of each fixed income trading desk, the national sales manager and representatives of the compliance department during which products sold to municipal and other customers and developments in those product types are reviewed as are the relevant trading desk reports on variations or modifications in the market that presently raise or are expected to raise materially new or different risks or that exhibit other characteristics that may require reassessment of the sales force’s understanding of the product; and (4) the practice of delivering, or providing electronic access to, copies of offering materials to purchasers of asset-backed commercial paper.”