Money Stuff: Gambling Is Not a Retirement Plan

Money Stuff
Bloomberg

Programming note

I don't know. Mostly I am dazed and heartbroken all the time, and it seems trivial and disrespectful to write a column about finance these days. But this is a financial newsletter, and like a lot of my readers I like having a mostly safe space for finance, so here we are.

A theme of this column over the past few years has been legal realism, the idea that "law," really, is just what officials do about disputes. Rules, the written laws, the constitution, are all "law" only insofar as they predict or explain the actions of public officials, or persuade those officials to do things. "That is all their importance, except as pretty playthings," as the great legal realist Karl Llewellyn put it. If this column sometimes seems cynical, it is mostly Karl Llewellyn's fault.

It seems to me that one central argument of the past few days has been about whether people with power should have to follow rules at all. America has good rules about freedom of speech and assembly and religion; it has a president who violently dispersed a peaceful protest and drove priests from their church so that he could pose for photographs outside of it. America has good rules against unreasonable searches and seizures, about the right to a trial by jury and due process of law; it has a long history of police killing black people with impunity. 

A message of the protests is that the police should have to follow the same rules as everybody else, that when they break the law they should face consequences. A message of the response to the protests is: No, they shouldn't. Is the law what it says? Or is it the raw fact of what the people with the guns and the tear gas do? I think I know the answer and it makes me sad. 

Also Money Stuff will be off tomorrow, back on Thursday.

Leveraged ETNs

Here are some people who bought leveraged exchange-traded notes and lost their money in the volatility of the last few months:

Cleveland-based Brad Davis stumbled upon UBS's leveraged mortgage REIT ETN while browsing commission-free trading app Robinhood. Like Mr. Zhu, he wound up being hit with heavy losses after UBS redeemed the note.

Ultimately, the 33-year-old doesn't fault Robinhood for allowing him to trade the products. "I knew they were risky," he said.

And:

"I don't think it's a good investment tool for most people. It's like a craps game," said Randall Simpson, a 50-year-old project manager and environmental planner from Phoenix who has traded that ETN on and off for five years. Mr. Simpson said he has lost nearly 90% of his initial investment.

Years of investing, though, had taught him never to put a substantial portion of his portfolio into ETNs, so his losses have been manageable, if painful, he said.

Good stuff. I have gone to casinos, and I have played craps, which I know has negative expected value, and I have lost the money that I brought, and I have been sad, because I would have preferred to make money. But then I have gone back to casinos and done it again. Not often or anything, not every day, not with all my money. Just occasionally, with a little bit of money, for entertainment. Somehow this process is fun, for me, in moderation. I do not have these feelings about leveraged exchange-traded notes, but I can comprehend how someone might.

Here are some more people who lost all their money on leveraged ETNs in the last few months:

When William Mark decided to get back into investing after the 2008 financial crisis, he looked past stocks and bonds. Needing to play catch-up with his retirement portfolio, the piping engineer decided to bet on a complicated product he hoped would deliver double-digit annual returns.

It worked so well—earning him 18% a year in dividends, on average—that he eventually poured $800,000 into the investments, called leveraged exchange-traded notes, or ETNs. When the coronavirus pandemic hit, he lost almost every penny.

"I'm 67 years old and I'm basically bankrupt in just two weeks," Mr. Mark said.

What. No.

James Zhu, a 78-year-old retired college professor and engineer, invested his and his wife's life savings into ETNs based on payment streams from mortgage bonds, bundled together by investment firms and amped up with leverage. …

The ETN Mr. Zhu bought from UBS slumped to less than 25 cents a share, from around $14 at the start of the year. Once the value of the ETN fell below $5, UBS had the option to redeem it. It did so on March 17, notifying investors they would be paid out $0.201 per security held. That resulted in a loss of $700,000 for Mr. Zhu, who had purchased the ETN at $13.35.

"We're too old to play those games," Mr. Zhu said. "It's too difficult for us. We were just looking for basic income."

I just. What? Here are the disclosure documents for that UBS thing, whose daunting name is something like "Exchange Traded Access Securities Monthly Pay 2xLeveraged Mortgage Real Estate Investment Trust Exchange Traded Notes Series B." It is possible that the sheer number of words in that name would be a red flag to an investor looking for basic income. Or not. It is possible that an investor looking for basic income would never even see the whole name. (I had to piece it together by expanding acronyms from two different disclosure documents.)

Zhu "is now suing his online brokerage, TD Ameritrade Inc., alleging the company made the ETN available to individual investors without providing sufficient disclosures." The prospectus does say in bold type on the first page:

The Securities do not guarantee any return of your initial investment and may not pay any coupon. You may lose some or all of your principal if you invest in the Securities. If the compounded leveraged monthly return of the Index (calculated as described herein) is insufficient to offset the negative effect of the Accrued Fees and the Redemption Fee Amount, if applicable, you may lose some or all of your investment.

That strikes me as not quite sufficient: The type is bold but fairly small, and it does not say, as it should, "this product is gambling and you will lose all your money." You may lose some or all of your money if you invest in anything; you want a stronger warning for a leveraged bet on mortgage REITs, which are pretty leveraged already. Also what are the odds that anyone has ever read the prospectus for a leveraged exchange-traded note?

But here's the real red flag about that ETN, from an article in TheStreet in March:

The UBS ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN Series B (MRRL) has been incredibly popular with high yield investors over its 5-year history. Throughout its lifetime, it often yielded 20% or more, giving it one of the richest dividend distributions in the entire marketplace. The fact that it paid out distributions monthly made it even more enticing for those seeking to generate monthly income from their portfolios.

I have long argued that the most important lesson of "financial literacy," one that is never taught in any "financial literacy" classes, is: If I offer you a 20% annual risk-free return, am I lying? The answer is yes, of course. UBS was not actually offering a 20% annual risk-free return—the ETN "often yielded 20% or more" but didn't advertise any fixed interest rate, and it said right on the front page that it was risky—but just knowing that single core fact of financial literacy would be sufficient to guide your investment decision here. "Ooh fun gamble, 20% return, maybe I'll take a chance on it": Fine, great, whatever. "Hmm this seems to offer monthly income, and a 20% return would help my retirement, guess I should put all my savings into it": No, bad, wrong.

The strangest part of this story is the different experiences of the people who bought leveraged ETNs as fun gambles and are now like "you win some you lose some," and the people who bought them as their retirement nest eggs and are now broke. It does not seem like it should be possible. Nobody is confused about what is happening at a casino; no college professors are at the craps table investing their life savings for stable income. Something about the disclosure regime isn't working here.

In addition to my views about financial literacy, I have argued in the past that good financial regulation would divide investments into normal ones and dumb ones. Normal ones would be, like, index funds or whatever, and anyone could buy them. Dumb ones would be penny stocks and private investments and, good lord, leveraged ETNs on mortgage REITs, and also anyone could buy them. But you'd have to get a Certificate of Dumb Investment before buying the dumb ones. I spelled out the application process once:

To get that certificate, you sign a form. The form is one page with a lot of white space. It says in very large letters: "I want to buy a dumb investment. I understand that the person selling it will almost certainly steal all my money, and that I would almost certainly be better off just buying index funds, but I want to do this dumb thing anyway. I agree that I will never, under any circumstances, complain to anyone when this investment inevitably goes wrong. I understand that violating this agreement is a felony."

Then you take the form to an SEC employee, who slaps you hard across the face and says "really???" And if you reply "yes really" then she gives you the certificate. …

If an article ever appears in the Wall Street Journal in which you (or your lawyer) are quoted saying that you were just a simple dentist, didn't understand what you were buying and were swindled by the seller's flashy sales pitch, then you go to prison.

As I read today's article in the Wall Street Journal about how simple piping engineers and college professors were swindled by the flashy sales pitch of 20% returns on leveraged ETNs of mortgage REITs, I could not help but think about this proposal. Obviously it doesn't quite work, because there is a vast middle ground between obviously fine things (low-fee broad-market index funds run by giant reputable providers) and obviously dumb things, and you'd have a lot of arguments about which high-fee actively managed concentrated specialist mutual funds, commodity funds, mid-cap individual stocks, etc., would go in which category. 

But once a thing says "2xLeveraged" right in the name, that's an easy one, that needs a certificate. The difficulty is in figuring out how to communicate this to investors, in a uniform way that they can understand and that does not rely on them reading 100-page prospectuses. You gotta stamp "this is not suitable as an investment for anyone" everywhere you advertise that thing. People will still buy it! They'll love it! "Ooh not suitable for anyone, that probably means a really juicy yield," they'll say, if they're financially literate and like a gamble. It's fine to cater to those people! There are a lot of them! But they are the only investors you should want.

Incidentally the Journal quotes Larry Swedroe of Buckingham Wealth Partners saying "If institutions aren't buying this, the retail investor shouldn't be either. Otherwise they're the sucker at the poker table that doesn't know it." I don't think that's quite right. Institutional investors have fiduciary obligations and so they do not generally take their clients' money to Vegas and play craps with it. Retail investors—that is, people—actually do go to Vegas and play craps, sometimes, with some of their money. Retail investors can, and do, consider the entertainment value of their investments when making investment decisions; they buy Tesla Inc. stock not only to get rich but also because Tesla is fun. These are not generally accepted as legitimate considerations for institutional investors, though obviously they have some influence. So if you are consciously looking for entertainment in your investments, there is no need to limit yourself to investments that institutions also use. You just gotta be clear about what it is that you're doing.

Client entertainment

A big part of the business of banks and asset managers is flying out to meet with clients, discuss their issues, understand their problems and propose solutions. In a global pandemic, bankers and fund managers mostly can't do that. They are adapting by doing a lot of video calls. This approach has tradeoffs. You build less personal trust and rapport on a video call than you do in person. But you can do a lot more video calls than in-person visits, and you spend a lot less time on planes so you can get more work done. We have talked about this phenomenon, and some bankers and fund managers suggest that some of it might be permanent. It turns out that not constantly flying around to see clients might be a better way to run a high-content client-focused business. Spending more time on the content, and more time on the clients, but less time on planes, might be better for you and the clients.

Another big part of the business of banks and investment firms, though, is sort of lite bribery: taking clients to expensive dinners and sporting events and concerts, throwing lavish conferences for them, going golfing with them. In theory you might discuss business on these outings, but they are also a way to build a personal relationship, and a sense of personal obligation, with the humans who control the clients' business decisions. If you spend $1,000 buying a corporate chief financial officer dinner, and she gives you a $1 million mandate to run her company's $100 million bond offering, then you are better off and she is better off and her company, sure, who knows, if you do a good job on the bonds maybe the company is better off too.

This is harder to do by video call. You can't go out to dinner or golf or the U.S. Open over video call. You can just send the client stuff, but that looks a little more like bribery: Going to a steakhouse with the client to discuss business and buying a nice bottle of wine with dinner feels like a reasonable business expense; shipping her a case of Petrus with a note saying "enjoy, and remember us for your next M&A deal" feels ickier. 

Still Wall Street is doing its best. Bloomberg's Annie Massa reports:

Country music artists including Darius Rucker and Luke Bryan performed from home for AllianceBernstein Holding LP's private wealth clients in a virtual concert last month that supported relief for Covid-19, said Adam Sansiveri, a managing director. The firm also sets up wine-and-cheese tastings for wealthy clients, featuring a remote sommelier.

I cannot imagine an event that screams "private wealth management" more than a videochat Darius Rucker concert, that's amazing, they can have all of my money. And:

Alex Caswell, a San Francisco-based wealth planner at RHS Financial, said care packages including items like face masks can do the trick. 

I hope the masks have logos? If, like, Société Génerale has branded face masks, I hope someone will send me one. Imagine going out in a pandemic shielded from harm by swag you got from your investment adviser. Later, when you're giving out a mandate, the adviser will be like "sure those other guys sent you a case of wine, but I might have saved your life."

I don't think anyone especially expects this to continue in a normalized world. The business of understanding clients' problems and finding solutions might actually be better accomplished remotely; the business of wining and dining them is pretty clearly best accomplished at a restaurant. 

Many in the industry expect virtual client entertainment won't last, particularity if a vaccine emerges, and that in-person meetings will again become the norm. ...

"In our business it's traditionally been based on trust and confidence," [Jim Hirschmann of Western Asset] said. "You have to earn that. It's difficult to earn that unless you're spending some time with someone face-to- face. And that will be a challenge for everyone."

There's still golf, though; there'll always be golf:

In areas with looser restrictions, some pre-pandemic pleasures remain.

"Golf!" said Tom Balcom, founder of 1650 Wealth Management, when asked how he's keeping in touch. His business is based in Fort Lauderdale, Florida. "We are playing a ton of golf with our clients these days since it allows us to socially distance from our clients while also spending time with them."

People are worried about surgically masked bank robbers

A lot of this column has historically been devoted to people's more or less arcane worries about what might cause or presage the next financial crisis. Bond market liquidity was a big one. Index funds. The cash-CDS basis, was a more arcane one, also covered interest parity. There are all sorts of things, buried in the plumbing of the financial system, that might worry you if you are inclined to worry. The likelihood that any particular one of these worries will cause a crisis is low, but that's how these things go. As it happens there was a big financial crisis recently caused by a global pandemic, which was never really on the Money Stuff bingo card. It's always the distant low-probability worries that get you.

So mostly this made me laugh but who knows, who knows:

The new head of a powerful banking regulator is not letting his first full week on the job pass quietly, warning that measures meant to contain the spread of the coronavirus — including mandates for the use of masks in public — could endanger the financial system.

Brian P. Brooks took over on Friday as the acting head of the Office of the Comptroller of the Currency, the federal agency that oversees the country's largest banks. Mr. Brooks, a former banker, sent letters to the country's mayors and governors about the negative effects of restrictions on public activity. Among them, he said: Face masks could lead to more bank robberies. …

"Certain aspects of these orders potentially threaten the stability and orderly functioning of the financial system," he wrote. …

Referring to reports not cited specifically in the letter, Mr. Brooks said that recent "face-covering-related robberies" showed that "broadly applicable face mask requirements are not safe or sustainable on a permanent basis." ...

The federal Centers for Disease Control and Prevention recommends that everyone wear a cloth face covering when they leave their home, to stop the spread of the coronavirus.

Imagine if this was true. (It's not true, bank robbery is no longer a lucrative crime and not a meaningful cost to banks, never mind a threat to the stability and orderly functioning of the financial system; if you were a serious bank regulator making a list of the threats to financial stability, this would not be in your top 1,000 concerns. But pretend for a minute.) Imagine the debates at the highest level of government as the public health officials argue that masks are necessary to prevent hundreds of thousands of deaths, while the banking officials argue that they will lead to a financial crisis that makes 2008, and March 2020 for that matter, look like child's play. How could a responsible government balance the virus's risk to human life with the threat of societal collapse from a financial crisis? I guess you could ask people to wear masks in public but take them off when they get to the bank teller? 

Narrative violation

This might be the best story I've ever read about venture capital:

Chamath Palihapitiya, a Sri Lankan native whose family received refugee status in Canada when he was a child, started as an outsider in the tech world. At Mayfield Fund, where he landed his first job in the VC world some 15 years ago, "Chamath wore the same jacket every day — a light-tan velour jacket — and jeans," one former colleague recalls. When the colleague asked Palihapitiya about his sartorial choices at the time, the young analyst talked about "low ROI," meaning he didn't want to spend his time and money worrying about clothes.

The outfit was also a not-so-subtle way for Palihapitiya to thumb his nose at the Silicon Valley dress code of the era: khaki pants and blue blazer. "His attitude was 'I'm not like all you guys. ... I'm smarter than you, and I'm going to show you,'" says the former colleague.

Peter Thiel wishes he could be that contrarian. "Everyone wears tan pants and a blue jacket, but what I am saying is, what if I wore blue pants and a tan jacket?" It is hard to improve on that trivial signal of difference. He's the opposite of everyone else, in the smallest and least important imaginable way.

(Fine fine fine Palihapitiya is actually interesting in more substantive ways, and there's a lot more in Michelle Celarier's profile. Still. If you are looking for ways to distinguish yourself in Silicon Valley early on, when you don't know much or have a track record, dressing the same as everyone else but in opposite colors is just such a good one.) 

Things happen

Citi CFO, One of the Few Black Wall Street Executives, Weighs In. Pinto Endured Lonely Weeks Co-Running JPMorgan as World Lurched. It's a Borrower's Bond Market as Amazon Gets Record Low Rates. Warner Music, ZoomInfo Poised to Boost IPO Market. Short the Target: The Specialist Funds Betting M&A Deals Won't Close. Coronavirus Hits Europe's Bad-Loan Securitization Market. Green Bond Crisis Premium Theory Debunked by Covid, Manager Says. Saudi Arabia, Russia Inch Toward Deal on Postlockdown Oil Cuts. Private Equity Lands Billion-Dollar Backdoor Hospital Bailout. KKR Spends Big and Fast to Avoid Mistakes of 2008 Crisis. "As the authors wrote in the study, dogs 'were as likely to release their distressed owner as to retrieve treats from inside the box, indicating that rescuing an owner may be a highly rewarding action for dogs.'"

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