Fire Your Broker!

Fire your financial adviser, unless they are a fiduciary

By John F. Wasik
Author, The Cul-de-Sac Syndrome

If you have a conventional stock broker or agent acting as a financial adviser working on commission, fire them.

Now that the SEC has endorsed a “uniform fiduciary standard of conduct” for brokers and investment advisers, there’s no reason to settle for anything less. This is a financial professional who, by law, must put your interests first.

In the past, the SEC did little to protect you from the ravages of a commission-driven world. Few knew the difference between a “financial consultant” (a broker) or a “certified financial planner” or “registered investment adviser.” The latter two are fiduciaries.

Having a fiduciary is one of the best investor protections around. If they wrong you, you can sue them. As a requirement of the Dodd-Frank financial reform law, the SEC needs to write the rules codifying this key investor protection and Congress needs to rubber stamp it.

It’s also time to move on to fix the broken system that deals with investor disputes. With brokers and agents, you typically sign away your right to sue. You are then subject to inadequate “suitability” standards that don’t offer much protection at all. Not only is it extremely difficult to sue, you are forced to settle most disputes in an industry-run arbitration system.

Countless investors are cowed by the process of proving that they were sold inappropriate investments by brokers. Although the industry doesn’t release the numbers — they should — most investor arbitration lawyers say that about 80 percent of wronged investors settle with brokerage firms for a fraction of what they are owed rather than go through arbitration.

Not surprisingly, investors don’t like the fact that even if they choose the arbitration process — which is billed as a cheaper alternative to litigation — it will cost them thousands in an attempt to get their money back and will face at least one industry member on a three-person arbitration panel. It’s like having a lawyer being the foreman of a jury in a legal malpractice trial.

The securities regulator FINRA is examining alternatives to remove the industry representative and give investors the right to sue in court. We can only hope these become permanent options.

The even bigger scandal is that securities brokers will be still largely self-regulated by an industry organization called FINRA. The group is charged with policing firms, providing background checks on brokers and running its arbitration forum.

How, you wonder, can an industry that powerful and wealthy effectively police itself and more than 600,000 brokers? The bumbling fictional film detective Inspector Clouseau would have been a better regulator in recent years.

FINRA missed the 2008 meltdown, the Madoff scam and failed to prevent more than $150 billion in losses in complex and structured investments that made their way into retail products like mutual funds, according to a soon-to-be published study I conducted for The Nation Institute.

Even if the new SEC rule covers all broker-dealers and advisers, it may not fully cover insurance agents, who sell securities products in the form of troubling variable and equity-indexed annuities. That’s another reason that you shouldn’t rely upon anyone other than a fiduciary for comprehensive financial advice.

In the past, the securities and insurance industries have relied upon more disclosure as an alternative to more protection for investors. Have you read a prospectus for a complex financial product lately? Does it clearly spell out the risks and costs? Most don’t.

Risky investments don’t need more disclosure — they already have plenty of that — they need cigarette-type labels that tell you up front “this investment is hazardous to your wealth.”

The SEC and FINRA still aren’t doing their jobs in an age in which ladders, toy packaging and dry cleaning bags have better warnings. Making most financial professionals fiduciaries is positive development, but you need to take the first step in hiring one now to ensure that your best interests are being served.

Home Finance Essentials

What mortgage brokers don’t tell you: Hidden penalties abound

By John F. Wasik (Reuters)
Author, The Cul-de-Sac Syndrome

There’s a host of information a mortgage broker or banker won’t tell you up front that may increase the cost of your financing.

You could pay much more on a mortgage than your initial quote rate based on a rating system used by government mortgage insurers Fannie Mae and Freddie Mac. Brokers and bankers rarely tell you this coming in the door. They want to lock you in to a loan as soon as possible. With rates rising, this is really important to know.

In the wake of the biggest real estate meltdown in American history, the devil’s in the details when you apply for a loan. This hidden rating system will penalize you with a higher rate if your credit score is low or you apply for certain types of loans. It’s being employed by Fannie Mae and Freddie Mac, the government’s captive mortgage entities, which account for about 80 percent of new loans now.

As of January 1, mortgage brokers and bankers have to tell you that you may not get the best rate if your credit report is flawed, although they may not give you essential details up front on what else could bump up your finance rate.

You need to ask about how you will fare in the Fannie/Freddie “risk-based pricing” regime, which is basically a computer-run scoring matrix run by your banker. Here are some factors that could raise your cost of credit:

• Credit scores (based on the FICO system) below 740.
• High loan-to-value ratios (the percentage of the property’s value that’s mortgaged). The more equity you have or the more money you put down, the lower your rate.
• Adjustable-rate, Interest-only or 40-year loans.
• Cash-out refinancings.
• Investment properties.
• Condominiums and cooperatives.
• Manufactured homes.
• Multiple-unit properties.

The risk-based pricing program evaluates the type of loan, your credit score and loan-to-value ratio and determine what “add-ons” will boost your quoted rate, if any.

A low FICO score — say below 620 — may add at least a half-percentage point to your loan. An interest-only loan may increase your rate by three quarters of a point. Those financing buying investment properties will likely pay the highest rates — up to one and three-quarter points more.

As with all loans, it pays to pull your credit report before you apply for a loan or refinance. Certain items such as record errors or bumping up against credit limits can be fixed fairly easily and raise your credit score. Outstanding bills such as medical debts may also hurt.

“We encourage people to be more informed,” says Dick Lepre, a senior loan officer with RPM Mortgage in San Francisco. “If they want the best rates they need to keep their credit score at or above 740. They must be vigilant about things such as medical collections which are often the result of confusion regarding medical co-payments.”

You can request a free credit report from www.annualcreditreport.com. Just be careful not sign up for credit monitoring services that will cost you additional monthly fees. The Federal Trade Commission spells out some of the pitfalls of so-called free services.

One other side effect of risk-based pricing: The stricter underwriting rules also make it more difficult to qualify for a loan, which is not much help to markets that are swimming in properties and won’t get back on their feet unless demand returns.

Hindsight seems to rule the day as the government struggles to alleviate the home crisis. If only the mortgage barons had some realistic underwriting standards five years ago. It would have prevented a lot of heartbreak.

Illinois and Its Financial Disease

The Prairie State pestilence: Pensions, budget woes spread

By John F. Wasik (Reuters)

Author, The Cul-de-Sac Syndrome

The fiscal malady that plagues Illinois — and its painful treatment — may be coming to a state, county or municipality near you.

What will cure this spreading pox on the populace? Higher taxes, lower spending and that rare commodity: political honesty.

I feel the pain since I live in Illinois and will pay higher taxes. This couldn’t be more personal to me. My daughters’ school district is owed state money and has fired teachers. My father’s teachers’ pension fund (among others) has been methodically underfunded for years. I went down to our state capitol last year with other University of Illinois alumni to lobby the state legislature to pay more than $400 million in unpaid education bills.

The Prairie State’s teaching moment was ignited by the Illinois legislature’s passage on January 11 of a tax increase that will raise $6.8 billion for state coffers and impose spending limits. The personal income tax will climb from three percent to five percent; the corporate levy from seven percent from 4.8 percent. It’s a mere finger in the dike as the state still needs to borrow to cover pension obligations. The rates may ratchet down over time.

Sad as this may sound, the Chicago Cubs have been managed better than the Illinois budget. The state was running a $13 billion budget deficit, which could balloon to $15 billion; it was in the worst fiscal shape of any state. Its shortfall was nearly twice that of California, which has nearly three times the population.

As a taxpayer, I’m outraged that things got this bad. As a citizen, though, I still want education to be fully funded, public-employee pensions to be honored and my state to invest heavily in infrastructure and job-creating programs.

While Illinois is a poster child for horrendous fiscal management, other states and municipalities are hurting in a similar way. Banking analyst Meredith Whitney says 50 to 100 municipalities may file for bankruptcy. JPMorgan Chase CEO Jamie Dimon recently echoed that concern.

In good times, many governments were generous with retirement and health benefits. They kept doling out the goodies with the assumption that widespread economic growth and a robust stock market would bail them out.

Yet the best intentions were declared on the road to hell. The stock market tanked three times in the last decade and took down public pension fund returns. Bond yields are abysmal. The ongoing housing crisis pummeled nearly every state by reducing income, property and sales tax revenues. Public pension payments were grossly inflated by bumping up salaries and bonuses in the final years of service.

The recession zapped state revenues by more than 30 percent between 2008 and 2009, the U.S. Census Bureau reported. That meant more teacher layoffs, furloughs for university professors and cutting services in countless communities. I went through my local school district’s budget with other citizens with a fine-toothed comb last year. It was like picking fleas off a lion.

The federal stimulus plan of 2009 helped somewhat, but not enough to offset a collective $130 billion state budget shortfall, according to the Center for Budget and Policy Priorities. Some 40 states project budget gaps totaling $113 billion for next year and 46 states posted a deficit last year.

With the new bailout-averse Congress in place, it’s unlikely that we’ll see another major stimulus plan being passed that will ease the burdens on state houses and city halls. In the interim, sacrifices will abound.

Pension formulas will be downgraded. Benefits will be cut. Public employees will have to dig deeper into their pockets to pay for pension and health-care benefits. And taxes will certainly be raised if cuts fail to restore balance.

Not all taxes need to be onerous and unfair, though. It’s once again time to consider a tax on carbon, raising a motor fuel tax that hasn’t kept pace with inflation and a tax on financial speculation.

If I believed that states could “grow their way” out of their fiscal messes, I’d say wait on new taxes. Yet that won’t likely be the case in most states where jobs have been permanently vacuumed away by emerging economies. The best tax would be one that spurs a reinvention of the economy while creating private-sector employment and channels money back into communities. It would be a hallmark of social capitalism.

If only Illinois (and many other states) wasn’t too broke to take this next step. It would restore my faith in Prairie Populism. I might even root for the hapless Cubs again.

Resolutions for the Financially Fussy

6 top financial trends for 2011

By John F. Wasik (Reuters)

Author, The Cul-de-
Sac Syndrome

Although the old Chinese curse “may you live in interesting times” has a certain irony about it, this year will certainly not be dull for investors.

To prepare for it, you’ll need a plan, as always. I suggest you craft an investment policy statement that puts down in writing your goals and the amount of money you don’t want to lose. Then plan accordingly.

Resolutions are not on my list, nor is a budget, which doesn’t work for most people. Just stick to growing your money in a sustainable way.

And don’t pay any attention to forecasts. Stocks will fluctuate. There will always be volatility. Focus on a point in the future and figure out how to get there. Here are some trends already in motion that will help you in the coming year:

More brokers will be fired. If you have an adviser who makes recommendations based on commissions, they will never fully be in your corner. Make your own decisions. Only hire advisers and planners who are fiduciaries and will take responsibility — and can be sued — for their bad advice. (Sometime this year, the Securities and Exchange Commission will rule on whether all brokers should be fiduciaries, which will be a beneficial change.) If you need an adviser, hire a fee-only certified financial planner (www.napfa.org).

More investors will buy into auto-pilot portfolios. Wall Street has snookered Americans for years. They have conned people into believing that diving in and out of stocks and funds will boost your wealth. Well, it does increase wealth — theirs. Investing doesn’t have to be complicated. Stop investing in actively managed funds, most of which don’t beat the market over time. Figure out how much risk you can take and find a passive index portfolio at Folio.com or myplanIQ.com that meets your criteria for risk. Every major fund and ETF company also offers passive funds. Automatically invest in your 401(k) and other retirement plans. Rebalance every year according to your investment plan statement and goals.

Your taxes can come down even more. Sure, the government will give you a break on payroll and income taxes, but there’s more you can do. Appeal your property taxes. Property prices are averaged over the past three years by most assessors, so you should be due a reduction in your assessed valuation. Check your payroll tax withholding. Getting a refund every year isn’t necessarily a good thing. You’ve essentially handed the government free use of your money for a year. If your withholding rate is too high, lower it and give yourself a raise.

Stocks will gain. According to data on Presidential market cycles, stocks rarely decline in the third year of a term. If you can afford the risk of being in the stock market, make sure you are invested through an all-market index fund such as the iShares Dow Jones US Index Fund (IYY). That way, all your bets are covered and you don’t get sucked into a risky single stock or sector.

Interest rates will rise. I know, pundits have been predicting this for the last three years and if the economy remains moribund this year, then they will be wrong again. If, however, demand for credit escalates and corporations start to spend their $2 trillion hoard of cash, rates will climb to reflect higher demand for credit. Just make sure you are not in long-term bond funds, because they will suffer the biggest declines. Treasury Inflation-Protected Securities or I Bonds will pay you more if inflation rises (www.treasurydirect.gov). Of course, any secure bond that you can hold to maturity will be okay.

Commodities will gain. A rising tide lifts all boats. A robust recovery in global economies means greater demand for commodities from coal to rare-earth metals. China, India and Brazil — and a host of other developing countries — all need several commodities to grow. Invest in a basket of them through the Powershares DB Commodity Index Tracking Fund (DBC), which follows a big basket of commodities.

Of course, all my market trends are based on the economy healing itself in the coming year and no major economic catastrophes.

There are always plenty of wild cards, though. That’s why it makes sense to create a low-cost, no-worry autopilot portfolio that samples big pieces of the stock, bond, real estate and commodities markets. It may not be interesting, but dull works better than daring and you don’t get penalized for betting wrong on trends.