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The risk of exotic investments - El Paso Inc.: Personal Finance

The risk of exotic investments

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Posted: Sunday, February 17, 2013 6:00 pm

Regulators across the country are confronting a wave of investor fraud that is saddling retirement savers with steep losses on complex products that until a few years ago were pitched only to the most sophisticated investors.

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 the minuscule interest rates being offered by bank deposits and government bonds.

Tens of thousands of them put their money into speculative bets promoted by aggressive financial advisers, including 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, 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 REITs.

LPL said it agreed, as part of the settlement, to reform its process for selling those REITs and other alternative investments.

J. Bradley Bennett, executive vice president 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 been dedicated to looking at the “proliferation of these products, to understand how they are being sold.”

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

Nothing new

Brokers promoting bad investments to unsophisticated investors is nothing new. But while the easy prey used to be the people looking to get rich quick, the pool has widened to include the much larger population of savers looking for ways to earn the kind of income that used to be 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 amount of 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 & Co. 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 many sections of the economy. Jeremy C. Stein, a Federal Reserve governor, said in a speech 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 IRA 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 – Beck bought the pitch because her broker had been around for years, and the product was offering 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,” 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. Beck and her husband have been reconfiguring their retirement and are planning to work longer.

Her lawyer, Andrew Stoltmann, is representing 10 of the broker’s customers, who have filed claims with FINRA saying that the broker used their money on his own “exotic, opulent” lifestyle.

There is no agreed-upon list of the financial products that have caused problems for yield-chasing invest gely unproven private companies, have been on the list of top enforcement concerns published by the national organization of state securities regulators every year since 2007.

Private placements are supposed to be available only to wealthy, sophisticated investors, but several loopholes, including relaxed procedures for verifying wealth, have allowed them to end up in the portfolios of less sophisticated retirement savers.

REIT risk

REITs have been one of the most heavily sold products because there are few rules about who can buy them.

Popular for years, REITs used to come primarily in funds that could be traded on public exchanges. The hot new version of REITs – the type that got LPL Financial in trouble in Massachusetts – can be bought and sold only in private transactions.

The outstanding amount of such nontraded REITs grew to $65 billion last year, from $43 billion in 2009, according to Direct Investments Spectrum. The private nature of these REITs has been advertised as a good thing, because it means the products are less likely to move up and down with the stock market. But it has also made it hard for investors to value their holdings or to get out when they need the money.

In addition to the Massachusetts case, FINRA issued a $14 million fine in October against a big purveyor of nontraded REITs in the New York area, David Lerner Associates.

FINRA put out a warning in January about one of the newest products being sold to retail investors: so-called business development companies, or BDCs, which hold the debt of small companies. The amount of money in outstanding nontraded BDCs grew to $4.5 billion last year from $8 million in 2008, according to MTS Research Advisors.

John Morgan, the securities commissioner in Texas, said that based on the complaints coming into his office, the appeal of alternative products appeared to be undimmed.

“The people that we talk to are just trying to find a stable source of income,” Morgan said. “The promoters have found a sweet spot here.”

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