Tuesday, 20 April 2010

Investor fraud, here and abroad

John Mangun
Outside the Box
Business Mirror

The United States Securities and Exchange Commission has charged financial giant Goldman Sachs with fraud in the conduct of its business of selling a particular investment package to their global clients.

It is unfortunate that the local press has not followed this story in depth because this will be the financial story of 2010. If the allegations are true, and I will bet hard-earned money that they are, this is one of the most blatant examples of investor fraud in recent memory.

In 2007, Goldman put together an investment package of subprime loans. As a normal practice, Goldman hired an outside firm to select the actual investments for this package. However, unknown to investors and never disclosed by Goldman, another firm, Paulson and Co., paid Goldman for the privilege of helping select which mortgages go into the investment portfolio. Now here is where it got interesting and exciting.

Paulson and Co. is a major hedge fund and they paid Goldman to structure another investment vehicle, based on the mortgages that Paulson selected for the first investment package, so that they could bet against it.

In effect, Paulson paid Goldman $15 million to select investments for Goldman clients and then Paulson immediately turned around and paid Goldman again to put together a deal so that Paulson can bet against the investments that they chose for Goldman’s clients in the first place. Guess what? Goldman’s clients lost $1 billion and Paulson earned $1 billion in profits.

When I became a New York Stock Exchange stockbroker in 1975, and having returned to Los Angeles from New York after passing the examinations, the senior broker in my office called me in. Jim Walraven was a hard-drinking old-timer who, incidentally, was married to a Filipina. He said, “Congratulations kid. You are now a stockbroker. And you now have a license to steal. Whether you decide to use it or not is up to you.” Investor fraud is nothing new and there are a hundred ways of separating hard-earned cash from investors to benefit someone else. In the 1970s, every morning, thousands of brokers for Merrill Lynch had a “recommended list” of three stocks they were expected to have their clients and prospective clients buy. Unknown to the clients and most of the brokers was that these were issues owned by large institutional clients of Merrill that were looking to get out of. They needed the little guys to provide a liquid market. Or these were shares that Merrill itself had in inventory that they wanted to dump. Or these were issues that big Merrill clients already owned and they needed retail buying to push the price up.

By definition, securities fraud, stock fraud or investment fraud is a practice that induces investors to make purchase or sale decisions on the basis of false or incomplete information.

Investor fraud covers a wide range of activities, from your average pyramid scheme down to seeing the company president drunk and looking very worried at a party and then using that “information” or “insight” to sell the stock.

The current Goldman situation does not fall into this category, but most investors are victims because of what W.C. Fields supposedly said: “You can’t cheat an honest man.” And by honest, I mean a person who is not motivated by greed.

Ultimately, most investor fraud can only succeed by playing on and to the greed most investors hold so strongly.

By global standards, fraud on the Philippine Stock Exchange is child’s play, unsophisticated and small in the big local picture. Having said that, I could probably write a book about all the incidents in the last 15 years where investors have lost money, lots of money, because someone smarter knew how to play their greed.

How do you avoid being a victim? I guess I should start by telling to you not be greedy or at least to keep your greed under control. But we both know that is not going to happen. We are all greedy and we will continue to be greedy. Fact of life.

But maybe what we can do is make our greed a little smarter to avoid being burned.

Most every case of investor-stock fraud starts with you (and your greed) being attracted to a certain issue. Like the Bible says, you need to keep yourself from the sweet words and smooth tongue of the stranger; from the seductive talk of some tempter.

The easiest way to attract attention is to show a sudden increase in volume traded. The price does not even have to go up. It is the volume spike that attracts attention. Your greed immediately thinks somebody knows something that you don’t. Big increases in price attract the attention of the regulators. Big increases in volume attract the attention of investors.

Company news attracts many investors to buy. And some companies seem to have significant news stories three or four times a year. One easy way to check if the news is valid or is simply stock-market propaganda is to look at the past. There are several local companies that have had dozens of big deals being announced over the years, none of which has ever come through. The latest news item may just be another sweet word to get you to buy so that someone else can sell.

There are dozens of other things that can be done to you that will cost you a fortune and you won’t even really know how it happened.

But this advice might help you avoid being hurt. The next time you want to buy a stock because of that news story, big volume or hot tip from a friend, ask yourself this: Would I have bought the stock without this new information? If the answer is no, it is probably better to stay away unless you are a large and sophisticated stock-market investor.

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