Friday, August 10, 2007

Liquidity Collapse: Advice for Rich Uncles

From the Big Picture:

I am going to relate an anecdotal tale that, as far as I can tell, is true. The actual story matters much less than the lessons it teaches, clearly enunciated at the end of this post.

Several years ago, I helped a firm develop a new Distressed Debt/CDO department. The history of the group that I brought in was a strong ability to trade distressed paper, and the expertise to package and resell it institutionally.

Initially, this worked out well for the firm. They managed to do a number of deals, getting their names on the offering books as co-leads with the likes of Merrill Lynch and Goldman Sachs. Very prestigious, huge fees, all good stuff.

After I left, I kept hearing all sorts of sketchy tales about the group: big turnover amongst staff, disagreements about costs, fights with the bond desk, issues with compensation. I chalked this angst up to the usual Wall Street "eat what you kill" philosophy.

Then I heard several stories: That the CDO desk was pitching their product to retail brokers, that this debt was getting placed in the accounts of individual investors where it had absolutely no business going into. Distressed debt and CDOs are sophisticated complex instruments that require a great of expertise in understand, and I was sure neither the retail brokers nor the clients knew these things.

Then, I hear tales that a retail broker from a rather disreputable shop joins the firm. He takes to the CDOs like a fish to water, placing them everywhere and earning huge fees. The rumor I keep hearing is that he even placed a $10 million block with a family member.

You can see where this is going: The $10 million dollar investment is now worth, best as anyone can figure, about $3 million -- assuming anyone can find a bidder. The commission on that one placement was a cool $700,000. The relative/client has gone postal, litigation threatened, all manner of ugliness. You just know this is going to end badly . . .

Now, its time for your 3 lessons to learn from this misadventure:

1. Advice for Investors: Never buy anything you do not understand. This is a very simple rule, regularly ignored by all too many people. If you don't understand what a company does, DO NOT BUY IT. If aan offering doc comes with a 157 page set of disclosures, unless you understand all the risks it contains, stay far far away.

2. Advice for Brokerage Firms: Never place institutional products with retail investors: As a rule, they do not have the sophistication to understand the product (see rule #1). More importantly, when this stuff gets offered to retail clients, it likely means INSTITUTIONAL CLIENTS HAVE REJECTED IT. Hence, the need to stick it somewhere other there where its supposed to go is likely proof that its got some bad mojo attached.

3. Special Advice for Rich Uncles: Don't give money to relatives, instead buy them a new Rolex. This sounds like a quite odd bit of advice, but follow my logic. When you give, say $10M ,to a relative, you are making a major financial decision based not on the merits of their skill set and experience, but rather, on a coincidence of blood relations.

This is not the basis for making a significant financial planning decision.

However, you then must speak to your nephew/niece/relative, with their parents (one of whom is likely to be your sibling). In front of these relatives, explain that your money has been carefully placed in the hands of professionals you have very painstakingly selected after great study of their long term track record (which the kid obviously does not have).

But in order to help them get started on their chosen career, here is a small present: This Rolex Watch (I suggest this one).

Tell them to wear it with pride: It will subtly convey how successful they are to their employers, peers and most importantly of all, their sales prospects. It reeks of their soon-to-be inevitable success.

Wish the best of luck in their new career! And walk away knowing that the $5,000 you just blew saved you untold millions in losses, and no end of grief at all future family gatherings

You'll thank me . . .

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