The Biggest Investor Scam, Part II

When average investors are ripped off by fly-by-nights, it’s bad enough. When they’re ripped off by the giants of the financial world, it’s much worse.

During the giant insurance company failures of the 1990s, for example, 6 million policyholders were caught in a moratorium; 2 million were frozen out of their savings.

During the Tech Wreck of 2000-2002, millions of Americans lost their retirement forever.

And during the Great Debt Crisis of 2007-2009, the asset destruction was even more widespread.

But if you think investors have learned the lessons of those disasters, look again …

As I told you one month ago, one of the main reasons consumers got caught in the insurance disasters was because of egregious conflicts of interest at ratings agencies like Standard & Poor’s, Moody’s and A.M. Best. (See “The Biggest Investor Scam on Wall Street.”)

The ratings were (and are) bought and paid for by the very companies being rated.

Similarly, a key reason investors got caught in the Tech Wreck and the Debt Crisis was the equally egregious conflicts of interest at Merrill Lynch, Morgan Stanley and dozens of other Wall Street firms.

Stock ratings were heavily influenced by special relationships between the “research” companies and the rated companies.

For reasons that should soon become evident, nearly all the ratings issued on stocks by major Wall Street firms are either “Buy” or “Hold.” They almost never issue “Sell” ratings.

What’s most shocking, however, is how common it is for Wall Street analysts to continue to lavishly praise on a stock, even if the company is on the verge of bankruptcy.

To better quantify this phenomenon, Weiss Ratings conducted a study on 19 companies that filed for Chapter 11 bankruptcy and that were rated by major Wall Street firms.

The result: Among these 19 bankrupt companies, 12 received a “Buy” or “Hold” rating from all the Wall Street firms that rated them.

Furthermore, the failed companies continued to receive those unanimously positive ratings … right up to the day they filed for bankruptcy.

Thus, even diligent investors who sought second or third opinions on these companies would have run into a stone wall of unanimous “don’t sell” advice.

Further, Weiss Ratings found that, among the 47 Wall Street firms that rated these stocks, virtually all were guilty of the same shenanigans.

The Wall Street firms led investors like lemmings to the sea, with rarely one dissenting voice in the crowd.

I tell you this now because it’s STILL mostly true.

And because for individual investors — and for the market as a whole — the ultimate consequences of these shenanigans can be catastrophic.

I go back in time for the best examples. But there are also similar examples today.

In April 1999, Morgan Stanley Dean Witter stock analyst Mary Meeker — dubbed “Queen of the Internet” by Barron’s — issued a “Buy” rating on Priceline.com at $104 per share.

Within 21 months, the stock was toast — selling for $1.50. Investors who heeded her recommendation would have lost 98% of their money, turning a $10,000 mountain of cash into a $144 molehill.

Undaunted, Ms. Meeker also issued “Buy” ratings on Yahoo!, Amazon.com, Drugstore.com and Homestore.com. The financial media reported the recommendations with a straight face. Then, Yahoo! crashed 97%; Amazon.com 95%; Drugstore.com 99%; and Homestore.com 95.5%.

Why did Ms. Meeker recommend those dogs in the first place? And why did she stubbornly stand by her “Buy” ratings even as they crashed 20%, 50%, 70% and, finally, as much as 99%?

One reason was that virtually every one of Ms. Meeker’s “Strong Buys” was paying Ms. Meeker’s employer — Morgan Stanley Dean Witter — to promote its shares, and because Morgan Stanley rewarded Ms. Meeker for the effort with a $15 million paycheck.

While millions of investors lost their shirts, Morgan Stanley Dean Witter and Mary Meeker, as well as the companies they were promoting, laughed all the way to the bank.

An isolated case? Not even close. In 1999, Salomon Smith Barney’s top executives received electrifying news: AT&T was planning to take its giant wireless division public, in what would be the largest initial public offering (IPO) in history.

Naturally, every brokerage firm on Wall Street wanted to do the underwriting for this once-in-a-lifetime IPO, and for good reason: The fees would amount to millions of dollars.

But Salomon had an issue. One of its chief stock analysts, Jack Grubman, had been saying negative things about AT&T for years.

A major problem? Not really. By the time Salomon’s hotshots made their pitch to pick up AT&T’s underwriting business, Grubman had miraculously changed his rating to a “Buy.”

What if it was abundantly obvious that a company was going down the tubes?

What if an analyst personally turned sour on the company? Would that make a difference?

Not really.

For the once-superhot Internet stock InfoSpace, Merrill’s official advice was “Buy.”

Privately, however, in e-mails uncovered in a subsequent investigation, Merrill’s insiders had a very different opinion, writing that Infospace was a “piece of junk.”

Result: Investors who trusted Merrill analysts to give them their honest opinion got clobbered, losing up to 93.5% of their money when Infospace crashed.

Merrill’s official advice on another hot stock, Excite@Home, was “accumulate!”

Privately, however, Merrill analysts wrote in e-mails that Excite@Home was a “piece of crap.”

Result: Investors who trusted Merrill lost up to 99.9% of their money when the company went under.

For 24/7 Media, “accumulate!” was also the official Merrill Lynch advice. Merrill’s internal comments were that 24/7 Media is a “piece of s6=t.”

Result: Investors who relied on Merrill’s advice lost 97.6% of their money when 24/7 Media crashed.

Subsequently, the Securities and Exchange Commission and other regulators agreed to a Global Settlement with 12 of the largest Wall Street firms.

Their aim was to encourage independent research and prevent similar disasters in the future.

Weiss Ratings, the only firm that had rated all dot-com stocks a “Sell” back in late 1999, was invited by the SEC to provide its research.

And research contracts were awarded by the SEC based on merit. If your track record was the best, you got the business. If it wasn’t … you didn’t.

End result: In this meritocracy, Weiss Ratings got the single-largest share of the research business.

But for the rest of Wall Street, the traps laid for investors changed very little. And the SEC failed to prevent the next ratings fiasco.

The Giant Debt Crisis

Fast forward to March 14, 2008, the day that Bear Stearns collapsed.

The Federal Reserve Bank of New York provided a 28-day, $29 billion emergency loan and Bear Stearns signed a merger agreement with JPMorgan Chase in a stock swap worth $2 per share, or less than 10% of Bear Stearns’ most recent market value at the time.

The sale price represented a staggering decline from a peak of $172 per share as late as January 2007 and $93 per share just two months earlier.

Wall Street stock analysts, still feeling some of the repercussions of their earlier fiasco, were now a bit more willing to issue negative opinions.

But the Wall Street bond rating agencies — Moody’s, S&P and Fitch — persisted in their old ways:

On the day of the Bear Stearns failure, Moody’s maintained a rating for Bear Stearns of A2; S&P was equally generous, giving the firm an A rating until the day of failure; and Fitch liked Bear Stearns even more, saying it continually merited a solid A+ throughout the 18-year period between Feb. 2, 1990, and March 14, 2008.

Investors lost everything. You must not let the same thing happen to you. Nor can you afford to accept Wall Street’s excuses.

When Bear Stearns went under, they said it caught them by surprise, and they couldn’t be blamed for not foreseeing what no one expected.

But 102 days before the failure, we warned that Bear Stearns “had sunk its balance sheet even deeper into the hole, with $20.2 billion in dead assets, or 155% of its equity; and was threatened with insolvency.”

Six months later, on Sept. 15, 2008, it was Lehman Brothers’ turn to go under, driving down the Dow Jones by over 500 points … the largest single-day drop since the days following the 9/11 attacks.

It was the landmark event that marked a new, more advanced phase of the debt crisis. One that sent shock waves of panic around the world that continued to reverberate for many years.

On the morning of the Lehman failure, however, Moody’s still gave it a rating of A2; S&P gave it an A; and Fitch gave it an A+.

As soon as the news hit, the latter two ratings agencies promptly downgraded the firm to D. But for investors trapped in Lehman Brothers shares … and for lenders stuck with its debt … it was far too late to take protective action.

Again, investors lost everything.

As with Bear Stearns, analysts said they were caught flatfooted due to circumstances no one could have foreseen.

But 182 days before its failure, we warned that Lehman was vulnerable to the same disaster that struck Bear Stearns. Nor was that our first warning. In the prior year, we wrote that Lehman was in a “similar predicament as Bear Stearns” because of an even larger, $34.7 billion pile-up of dead assets, or 160% of its equity.

Meanwhile, Fannie Mae and its sister company, Freddie Mac, were placed under conservatorship of the U.S. government on Sunday, Sept. 7, 2008. The U.S. Treasury committed to bailout funds of $100 billion for each, the largest bailout for any company in history at that time.

Common and preferred shareholders were wiped out, and debt holders risked suffering severe losses.

But because of Fannie Mae’s status as a government-sponsored enterprise, the Wall Street ratings agencies completely missed it.

Standard & Poor’s first gave the company a triple-A rating nearly seven years earlier and never changed it.

Moody’s did the same more than 13 years earlier and never changed it.

Fitch had continually maintained its triple-A for Fannie Mae for more than 17 years and never changed it.

However, six years earlier, we wrote “Fannie Mae is already drowning in a sea of debt. It has $34 of debt for every $1 of shareholder equity. That’s big leverage and of the wrong kind.

“Plus, the company has only one one-hundredths of a penny in cash on hand for every $1 of current bills. Think Fannie Mae can’t go under? Think again.”

We witnessed a similar pattern of Wall Street complacency, bias and flagrant disregard for investors with the failures of

• New Century Financial, which filed for Chapter 11 bankruptcy in 2007;
• Countrywide Financial, which was bought out by Bank of America in 2008;
• Washington Mutual, which filed for bankruptcy in September of that year; and
• Wachovia Bank, which signed a deal to be acquired by Wells Fargo by year-end 2008.

And in each case, our ratings warned consumers well ahead of time.

The Ideal Way to Play a Bull Market Rating

The flip side of warning investors of future dangers is leading them to the cream-of-the-crop investments that can outperform the market by a mile.

It was reported in The Wall Street Journal that the Weiss Stock Ratings ranked No. 1 in performance, beating all other firms covered.

That included the research of all major Wall Street firms like Goldman Sachs and Morgan Stanley. And it also included the major independent firms as well.

Further, our own studies show that simply by buying our highest rated stocks with the strongest performance, an average investor could have beaten the S&P 5.8-to-1 since 2007.

But the bull market won’t last forever. In the next great recession, brace yourself for similar shocks.

Here are the key lessons to learn …

Lesson 1: You cannot trust the established ratings agencies such as S&P, Moody’s, Fitch and A.M. Best.

Even after the Great Recession, their business models never changed.

Until they do, take their ratings with a grain of salt. And rely primarily on providers of truly independent ratings.

Lesson 2: Size alone is no assurance of safety. Quite the contrary, often the bigger the companies are … the more elaborate the cover-ups … and the harder they fall.

Lesson 3: Even in the best of times, large financial failures are possible. In a severe recession or depression, they are inevitable.

Lesson 4: Inflated and conflicted ratings played a key role in supporting a speculative bubble. Their downfall could play an equally important role in deepening the next recession.

Lesson 5: Don’t count on the Fed, the U.S. Treasury or even President Trump to come to your rescue.

They’ve been there, done that. Massive bank bail-outs. Unprecedented money printing. And now the greatest tax cuts in 31 years.

No, the party is not ending yet. It still has legs and there’s still big money to be made.

But no matter when the bull market ends, you can make significantly more money … and do a much better job of avoiding the downside … when you have objective ratings free of all conflicts of interest.

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Good luck and God bless!

Martin