U.S. Financial Reform Update: What it Means for Canadians

By: Cameron Passmore

With one of the strongest financial services sectors in the world, Canadians have been able to watch the recent volatility in the U.S. and other economies at a relatively safe distance. While we may have felt their ripple effects, Canadians largely avoided the trauma of bank failures, scores of corporate bailouts, massive foreclosure rates and decimated investment portfolios.

With hindsight we can look back at the beginnings of the crisis in 2007 and see what triggered much of the damage. The end of a U.S. housing price bubble, “subprime” and wildly adjustable rate mortgages, and Wall Street’s selling of unstable securities built on these “junk” mortgages all combined to destabilize the markets. The house of cards that banks and investment firms created based on mortgage-backed securities (MBS) and collateralized debt obligations (CDOS) fell apart quickly when home prices declined and borrowers began defaulting on their loans.

In the U.S., the result of all this has been President Barack Obama’s proposal for a sweeping overhaul of the financial regulatory system on a scale not seen since the Great Depression. U.S. regulators want more authority to monitor all financial instruments, from mortgages to complex securities, such as derivatives. Financial services firms will be required to reduce debt and hold more money in reserve to ride out storms. And, the government wants authority to seize and operate collapsing firms to avoid “too big to fail” bailout scenarios.

What Does It All Mean?

So, what does this mean to you and other investors? For Canadians who think these problems could never happen here, there is one element of the recent U.S. meltdown that could easily have erupted in our financial sector. In Canada and the U.S., we readily allow banks and investment firms to play in all areas of the sandbox. In other words, a financial institution can advise clients to buy specific securities or instruments, while at the same time profiting from creating those investment vehicles or engaging in hedging against their success.

Recently, PBS broadcast journalist Charlie Rose interviewed Lloyd Blankfein, CEO and Chairman of Goldman Sachs, on that firm’s role in the crisis and its impending criminal prosecutions and civil lawsuits. While not admitting guilt, Blankfein concedes some investment vehicles they created and some of their actions are regrettable, saying: “In hindsight, I wish we had not done some of those things.”

Problems with conflicts of interest have given rise to a U.S. bill championed by Senator Christopher Dodd. The so-called Volcker Rule would require banks to stop trading for their own account — “proprietary trading” that returns about 10% of the overall revenue of firms such as Goldman Sachs. Not surprisingly, Blankfein is opposed to the Volcker Rule, asserting it would require the firm to “forego revenue opportunities.”

It is that type of thinking — rejecting safeguards that interfere with the opportunity to make a buck — that can get some advisors and their investors in trouble. If you walk away with any wisdom from the recent U.S. financial woes, it should be to question closely the investment advice and motives of anyone who is trying to part you from your money. Questions such as “Does the firm or institution, package or create what is being sold? Does the firm trade in the same securities or funds you are buying? Do you even know what fees are being charged?

That last point is surprisingly important. A recent study by U.S.-based BlackRock Inc. found that almost half (47%) of high-net worth investors with mutual funds mistakenly believed their funds did not charge any management fees. Asking questions about how your advisor and his or her firm make money is smart.

Conflicts of interest develop all too easily in many financial institutions, mutual funds and investment firms, regardless of the country of origin. As an investor, you can mitigate your risk by learning more not only about what you are investing in but also who is advising you to invest.