March 25, 2023

Off the Charts: Shades of Prerecession Borrowing

The amount owed on loans secured by investments rose to $384 billion at the end of April, according to data compiled by Finra, the Financial Industry Regulatory Authority. It was the first time the total had surpassed the 2007 peak of $381 billion, a peak that was followed by the Great Recession and credit crisis.

The accompanying charts show the level of outstanding margin debt since 1960, both in dollars and as a percentage of gross domestic product. The latest total of borrowing amounts to about 2.4 percent of G.D.P., a level that in the past was a danger signal.

Rising margin debt was once seen as a primary indicator of financial speculation, and the Federal Reserve controlled the amount that could be borrowed by each investor as a way to damp excess enthusiasm when markets grew frothy. But the last time the Fed adjusted the margin rules was in 1974, when it reduced the down payment required for stocks to 50 percent of the purchase price, from 65 percent. That came during a severe bear market.

Since then, the Fed has been on the sidelines. The view there, and among professional investors, has been that far greater leverage was available through options and futures, not to mention more exotic derivatives, so changing the rule would have little effect on levels of speculation.

Nonetheless, margin loans have remained popular among many individual investors, who tend to raise their borrowings during times of market optimism and to reduce them when markets are falling. Thus the margin debt levels now may provide an indication of popular enthusiasm for investments.

The first time in recent decades that total margin debt exceeded 2.25 percent of G.D.P. came at the end of 1999, amid the technology stock bubble. Margin debt fell after that bubble burst, but began to rise again during the housing boom — when anecdotal evidence said some investors were using their investments to secure loans that went for down payments on homes. That boom in margin loans also ended badly.

The charts show the changes in the Standard Poor’s index of 500 stocks during the 12 months before the margin debt level reached 2.25 percent of G.D.P., while it stayed at that level, and during the 12 months after the debt level fell below that figure. The figures are indexed to zero at the end of the first month that margin debt reached 2.25 percent of G.D.P.

In each case, there were double-digit increases in share prices during the year before margin debt got to that level. In the first two, the stock market decline began while margin debt was at the high level, and accelerated as debt levels fell — presumably because investors were liquidating securities that were losing money.

If that pattern repeats, it could indicate that the stock market rally, which carried the S. P. 500 to record levels in May, will not last much longer.

Perhaps offering some hope that pattern will not repeat is the fact share prices are lower now — at least relative to the size of the economy — than they were at the prior peaks. As it happens, the S. P. 500 was a little below 1,500 in 1999, and again in 2007, and again this past January, when margin debt rose to 2.25 percent of G.D.P. But corporate profits now are more than double what they were in 1999, according to government estimates.

Floyd Norris comments on finance and the economy at

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Bucks Blog: A Financial Self-Defense Guide for Older Americans

The board that oversees the certification of financial planners has developed a guide to help older Americans avoid fraud and abuse.

The guide, “Financial Self-Defense for Seniors,” was developed by the Certified Financial Planner Board of Standards, a nonprofit group that administers the credential for “certified” financial planners. To earn the “certified” designation, financial professionals must meet certain requirements for education and experience and pass a difficult exam on a variety of financial topics.

The new guide lists “red flags” to watch for, and offers advice for vetting financial professionals before you sign up to work with them. It suggests, for instance, asking if, in offering advice, the adviser is required to use the “fiduciary” standard. That standard obligates the professional to put the client’s interests first and to fully explain any conflicts of interest that might affect the advice provided to you. (All planners with the “C.F.P.” designation must adhere to the fiduciary standard, the board says.)

Here are other tips from the guide:

  • Ask the professional what organizations supervise his or her services. Brokers, for instance, are supervised by FINRA, the Financial Industry Regulatory Authority. Those who offer investment advice are overseen by the federal Securities and Exchange Commission or a state securities regulator. You can check with those organizations to see if the adviser has a disciplinary history. (The guide offers a list of resources, including steps for filing a complaint.)
  • If you don’t understand a product, don’t buy it. Ask what risks it involved, and make sure you understand the answers.
  • Don’t allow a professional to visit you at home. If you’re considering working with someone, go to the business location — and take a friend or family member with you, to listen to the conversation and discuss it later.
  • Get a written description of the risks and benefits of any investment you are considering.
  • When filling out paperwork, don’t leave blanks that could be filled in without your knowledge or consent. And make sure you request a copy stamped “final” for your review.
  • Ask the professional, “What do you get paid if I make this investment?” The fact that adviser gets a commission doesn’t necessarily signal a problem, the guide says, but if the benefits to you aren’t sufficient to justify the payment, you may want to look at other options — and for someone else to work with.
  • When considering a reverse mortgage to tap into home equity, make sure it is backed by the Federal Housing Administration.

Have you had an experience in which you were misguided by a financial adviser? What did you do?

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Wave of Investor Fraud Extends to Ordinary Retirement Savers

The victims are among the millions of Americans whose mutual funds and stock portfolios plummeted in the wake of the financial crisis, and who started searching for ways to make better returns than those being offered by bank deposits and government bonds with minuscule interest rates.

Tens of thousands of them put money into speculative bets promoted by aggressive financial advisers. The investments include private loans to young companies like television production firms and shares in bundles of commercial real estate properties.

Those alternative investments have now had time to go sour in big numbers, state and federal securities regulators say, and are making up a majority of complaints and prosecutions.

“Since the crisis, we’ve seen more and more people reaching out into different types of exotic investments that are a big concern to us,” said William F. Galvin, the Massachusetts secretary of the commonwealth.

Last Wednesday, Mr. Galvin’s office ordered one of the nation’s largest brokerage firms, LPL Financial, to pay $2.5 million for improperly selling the real estate bundles, known as nontraded REITs, or real estate investment trusts, to hundreds of state residents from 2006 to 2009, in some cases overloading clients’ accounts with them.

LPL said it agreed, as part of the settlement, to reform its process for selling such alternative investments.

There are few good statistics on the extent of the problem nationally. But cases are mounting in the offices of regulators like A. Heath Abshure, the securities commissioner in Arkansas, where a majority of the 66 open securities cases involve complex investments sold to less sophisticated investors looking for a steady return.

J. Bradley Bennett, chief of enforcement at the Financial Industry Regulatory Authority, or Finra, Wall Street’s self-regulatory group, said that for the last two years, 10 staff members have looked at the “proliferation of these products, to understand how they are being sold.”

“It’s got our attention,” he said. “We recognize the trends.”

Brokers promoting bad investments to unsophisticated investors is nothing new. But while the easy prey used to be people looking to get rich quick, the pool has widened to include savers looking for ways to earn the kind of income once reliably available from traditional investments.

Regulators are warning investors that the dangers are unlikely to recede, given the Federal Reserve’s pledge to keep interest rates near zero and the push among financial firms to earn more revenue from so-called alternative investments marketed to retail investors. Brokers are eager to sell these investments because they often bring in higher commissions than standard mutual funds and stocks.

The money that retail investors have in alternative investments in the United States, ranging from baskets of commodities to mutual funds that employ sophisticated trading, more than doubled from 2008 to 2012, to $712 billion from $312 billion, according to McKinsey Company. Many of the products hold out the promise of higher returns while ostensibly being immune to the volatility of stock markets.

The phenomenon of investors’ actively moving money in pursuit of higher interest rates, known as chasing yield, is reverberating through the economy. Jeremy C. Stein, a Federal Reserve governor, said in a speech on Thursday that he worried that investors desperate for yield could be creating a bubble in widely available investments like junk bonds.

Mary Beck, a furniture business consultant in Pasadena, Calif., said that in 2008, as the stock investments in her husband’s I.R.A. began to fall quickly, the couple moved $470,000 to a new product recommended by their broker.

While the offering was unfamiliar — part ownership in a fleet of luxury cars — Ms. Beck bought the pitch because her broker had been around for years, and the product offered what seemed to be a modest annual interest rate of 7 percent.

“We knew that 12 percent wasn’t realistic, but 7 percent seemed realistic,” Ms. Beck said. “To us, it was a very conservative way to ensure that we’d increase our savings.”

Soon after they stopped receiving interest payments, the Becks lost their money when the venture went bankrupt in 2012. Ms. Beck and her husband have been reconfiguring their retirement and are planning to work longer.

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DealBook: MF Global Dodged Capital Requirements, Study Says

Jon Corzine, former chief of MF Global, at a House panel in 2011.Alex Wong/Getty ImagesJon Corzine, former chief of MF Global, at a House panel in 2011.

Under pressure from regulators last summer to increase its capital cushion, MF Global moved some of its risky European debt holdings to an unregulated entity in an effort to avoid having to raise extra money, according to a new report. The revelation raises new questions about MF Global’s actions in its last months — in particular, how it responded to regulators. The brokerage firm had previously disclosed that it had met the capital requirements, but never mentioned that it had transferred some bonds rather than raising additional money. The shift was detailed in a report by Louis J. Freeh, the trustee overseeing the bankruptcy of MF Global. The report is separate from the one issued Monday by James W. Giddens, the court-appointed trustee charged with recovering money for MF Global’s customers.

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“This strategy allowed the MF Global Group to transfer the economic benefits and risks,” thus reducing the “regulatory capital requirements,” the report by Mr. Freeh said.

Shifting the bonds to an unregulated entity to avoid capital requirements is unusual at financial firms, corporate accounting specialists say. Regulators expressed concerns about the maneuver, although ultimately they did not block it. The Financial Industry Regulatory Authority, Wall Street’s self-regulator, said it lacked jurisdiction to pursue the matter further.

“It’s a shell game, and the problem is the regulators buy off on this stuff, and then when it implodes, they always look so stupid,” said Lynn E. Turner, the former chief accountant at the Securities and Exchange Commission. “Common sense says why would you accept these types of shenanigans?”

The new details are part of Mr. Freeh’s 119-page report outlining the status of his investigation of MF Global, which collapsed last October after misusing roughly $1 billion of customer money. In the report, which was filed in Federal Bankruptcy Court in New York late Monday, Mr. Freeh said that creditors such as banks and big investors could have more than $3 billion in claims against the company.

“This report gets to the heart of the complex intercompany relationships inherent in a global firm that provided financing for its affiliates and subsidiaries all over the world,” said Mr. Freeh, a former director of the Federal Bureau of Investigation. “We believe this report provides increased transparency as to how the firm’s capital flowed through these entities.”

Mr. Freeh, who is responsible for recovering money on behalf of MF Global’s creditors, has cast a worldwide net. The report lists claims against affiliates from Britain to Mauritius. But Mr. Freeh’s biggest potential target is Mr. Giddens, the trustee whose job is to return customers’ missing money.

Mr. Freeh has filed claims for more than $2.3 billion against a separate dealer entity that Mr. Giddens is overseeing, drawing the lines in an increasingly tense turf war between the men.

Ultimately, their missions — to claim a limited pool of money — are at odds. Mr. Giddens is working to get money from that pool for farmers, traders and hedge funds left with a roughly $1 billion hole in their accounts. Mr. Freeh is vying for much of the same funds, but on behalf of businesses and banks that are owed money by MF Global.

While publicly the men have played down tensions between them, privately the fight has become more acrimonious. Mr. Freeh’s report is littered with references to Mr. Giddens’s office not producing documents and information.

The tension could have affect customers. Mr. Giddens is expected to set aside a substantial amount of money because of Mr. Freeh’s claims, which would “take those assets out of the pool available for distribution to customers until the claims are resolved,” said Kent Jarrell, a spokesman for Mr. Giddens.

Mr. Giddens released his own status report earlier Monday. The 275-page document covered in painstaking detail the final weeks before MF Global’s collapse, and raised the prospect of filing civil suits against top executives at the firm to recoup assets, including the former chief executive, Jon S. Corzine.

The report provided the most exhaustive accounting yet of what transpired at the firm, including its decision to tap customer money with repeated frequency as the business suffered a crisis of confidence.

What the reports from Mr. Freeh and Mr. Giddens have in common is the portrait they paint of MF Global and its leadership. The firm that emerges from their pages is one that was constantly flying by the seat of its pants, prone to risky decisions with few controls to keep it in check. While the chaos in the last days of the firm is well known, what the reports show is that aggressive behavior was taking place well before the market took its toll.

Mr. Freeh is still conducting an investigation of what happened at the commodities brokerage firm. Yet, the details on MF Global’s efforts to skirt capital rules raise additional questions about what the firm — and its regulators — were doing to address a looming crisis.

Months before MF Global filed for bankruptcy, regulators raised concerns about the firm’s $6 billion bet on European sovereign debt. At the time, worries about highly indebted nations like Greece, Spain and Italy were causing volatility in the financial markets.

Given the market turmoil, the Financial Industry Regulatory Authority, or Finra, demanded that MF Global set aside extra money in case the trades soured. But MF Global objected, appealing the regulator’s ruling to the Securities and Exchange Commission. Mr. Corzine, the former Democratic governor of New Jersey and a former head of Goldman Sachs, lobbied the S.E.C. to back down, flying down to Washington from New York to make his appeal in person.

He lost. The agency sided with Finra. In a September 2011 filing, MF Global said it had “increased its net capital and currently has net capital sufficient to exceed both the required minimum level and Finra’s early-warning notification level.”

But the disclosure did not give the full picture. While MF Global did move some cash around to protect against losses, the firm also transferred roughly $3 billion in holdings of Italian bonds from its brokerage arm to “FinCo,” an unregulated entity of the firm, according to Mr. Freeh’s report. By doing so, MF Global met its requirements without having to raise money.

At the time, MF Global held about $6 billion in the debt of Belgium, Ireland, Italy, Spain and Portugal, representing about 14 percent of its assets and nearly five times the equity of the firm. The Italian bonds represented about half the firm’s risky European position.

After Finra’s capital request became known in October, investors were rattled, pushing the shares of MF Global sharply lower. Ratings agencies warned that they might cut the firm’s credit ratings, escalating the fears in the marketplace. The effect of downgrades from Moody’s Investors Service and Standard Poor’s were worsened by a poor earnings report. On Oct. 31, MF Global filed for bankruptcy.

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High & Low Finance: Statements Skip Over REIT’s Woes

And yet some people who purchased an investment in hotels then have received comforting account statements from their broker, David Lerner Associates. If you believe those statements, the value of their real estate investment trust has never wavered.

Unfortunately, that is nonsense. The real estate investment trust, Apple REIT Eight, is facing significant problems. It has failed to make mortgage payments on four hotels it owns, and says it may have to surrender the properties to the lenders. Yet it has not written down the values of those hotels on its financial statements.

It has made monthly payouts to investors, but much of the money needed to make those payments was borrowed. At first, borrowing was easy, but it seems to have become more difficult. The last loan was made after the trust’s chief executive agreed to personally guarantee repayment.

Yet every month David Lerner has sent out statements showing the value of shares in Apple Eight at $11 each, just what most of them sold for. The first investors in 2007 were sold shares at $10.50, so their statements indicate gains.

This week the Financial Industry Regulatory Authority filed a disciplinary action against Lerner, accusing it of misleading investors in selling the current Apple REIT, No. 10. It said Lerner was “targeting unsophisticated and elderly customers with unsuitable sales of this illiquid security” and misled them regarding the record of earlier Apple funds.

Just a day later, an investment management company began a tender offer for up to 5 percent of the outstanding Apple Eight shares. It did not offer $11, or anything close to that amount. It offered $3.

The Apple REITs are perhaps the most egregious of a little-known class of investments. unlisted REITs, that are sold to investors who think they are being cautious. They are registered with the Securities and Exchange Commission, but not publicly traded. The Apple REITs will repurchase a small number of shares each year, but most investors will have to wait five years or more to get their money back, when the REIT either liquidates or begins to trade publicly.

Oddly, the very lack of liquidity is used as a selling point by brokers selling to investors who fear the volatility of the stock market and crave a steady income. The fact that the steady income may simply come from borrowing more money is not emphasized. Apple Eight buyers expected an 8 percent annual payout, although the figure was reduced to 7 percent last year.

In bringing charges against David Lerner, a company that claims to emphasize safe investments and advertises heavily in Florida and New York City, Finra chose to focus on the sale of the shares to customers for whom such risky investments were not appropriate, as well as claiming deception in the way the shares were marketed.

Lerner, which gets most of its income from selling the Apple funds, used to primarily be a seller of muni bonds. Last year, Finra charged it with overcharging customers through excessive markups of bonds sold to them. Lerner denied the allegations and is still fighting them.

In its response to the latest charges, Lerner evidently decided that the best defense is a good offense. After calling the complaint “baseless” and “rife with falsehoods, distortions, and misleading statements,” the firm, which uses the initials D.L.A., chose to bring up Bernard L. Madoff, who was convicted of organizing the largest Ponzi scheme in history:

“What is obvious is that D.L.A. and other small firms have become the scapegoats for Finra’s utter failure to address Madoff’s fraudulent scheme.”  

When I asked Lerner officials which other small firms had been badly treated, they referred me to a column in The New York Post that quoted an anonymous broker who complained that Finra was unfair, but did not cite any examples.

Bringing up Mr. Madoff may be relevant here, but not for the reasons Lerner cited. Mr. Madoff preyed on wealthy investors who wanted good returns without volatility.

There is no question that the Apple REITs own real hotels, and are not Ponzi schemes. But the lack of volatility shown in the Lerner account statements has been a lure for customers and is misleading.

The nontraded REIT sector is big but generally sails below the investment horizon. Last year sales of such shares by sponsors raised $8.3 billion from investors. That was up from $6.4 billion the year before but below the 2007 record of $11.8 billion, according to figures compiled by Blue Vault Partners, a research firm.

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