"Trust Deficit" Plagues Industry
October 26, 2012
By almost any measure, trust in financial services firms have fallen to new lows or close to them.
"Trust in banks has collapsed," said Paola Sapienza, co-author of the Chicago Booth/Kellogg School Financial Trust Index, after its latest quarterly survey came out at the end of July. In one quarter alone, trust in banks fell five points to a low of 27%.
But that is better than mutual funds. Only 25% of investors say they had confidence in the operators of investment collectives.
"Folks, we have a trust deficit,'' said Doug Hodge, the chief operating officer of Pacific Investment Management Co., which operates the Total Return Fund, the world's largest mutual fund, with more than a quarter-trillion dollars of assets in it.
The deficit began with the credit crisis of 2007-2009, when esoteric investment products based on sub-prime mortgages imploded and nearly took the global economy with it. But, since then, there have been a spate of technically-driven scares in stock markets, running from the May 6, 2010 Flash Crash, through the August 1, 2012, flood of erroneous orders from Knight Capital.
In fact, in the last year alone, as the industry has tried to recover trust, there have been a new slew of incidents that undermine it, Hodge noted at the Securities Industry and Financial Markets Association annual meeting last week in New York.
These include: the robotic signing of foreclosures on homes, the alleged use of customer funds by MF Global to stave off collapse, the admitted embezzlement of customer funds by Peregrine Financial Group, the apparent assistance given to terrorists, drug lords and Iran in laundering money by HSBC, the multibillion-dollar trading loss suffered by JPMorgan Chase and pinned on a London trader known as the Whale, and the rigging of the world's premier benchmark interest rate, the London Interbank Offer Rate.
These scandals reflect a false equation, Hodge said, that money is an end, in itself. Rather, for financial services firms, such as PIMCO, "money is a means to an end,'' he said.
Fund firms are "stewards of capital markets,'' helping investors achieve their goals, protecting their money and providing them with adequate liquidity, when they want to sell what they own and buy what they don't.
"The human suffering,'' from the industry's fall from grace, he said, "has been immense and the fallout may last for generations."
The consumer is "financially wounded,'' he said. The economy is anemic. Markets are volatile. There are 'structural headwinds,' such as huge government debts and deficits. And, a sweeping overhaul of financial regulations is underway, worldwide.
"Frankly, so far, we haven't done so well,'' he said.
The key is to focus on making sure the balance sheets of financial firms are safe and sound, he said.
In 2007 and 2008, that was not the case. Bear Stearns couldn't handle the implosion of its own supposedly high-grade credit funds. Lehman Brothers failed, in the largest bankruptcy filing in U.S. history. Lehman had $600 billion in assets, but huge exposure to the mortgage market. Its collapse, in turn, led to the breaking of the buck at the nation's oldest money market mutual fund, the Reserve Primary Fund. Its net asset value could not be maintained at a $1 a share, because of the sudden drop in the value of its Lehman holdings.
The U.S. Treasury and government swooped in with trillions of investment to prop up financial firms such as AIG and the nation's economy itself. This "privatized profits and socialized losses,'' Hodge said.
Not a prescription for investor trust that they would profit in the future from their dealings with financial service firms.
"We lost good will,'' Hodge said. The industry has to redress "where we lost our way."
That may start with preserving the integrity of balance sheets. But it also means the industry has to work with regulators and governments to restore economies. The World Economic Forum and McKinsey Consulting have estimated, he noted, that $100 trillion of credit is needed around the world to sustain existing growth plans.
But, in the end, the industry needs a "cultural transformation,'' he said.
"We should not be all about profit. We cannot be all about profit,'' Hodge said. "We are stewards. We are protectors" of financial markets.
Clients' interests must come first, he said, and risk management an integral part of daily operations.
But most of all, firms must demonstrate to clients, governments and other constituencies a "sense of stewardship."
That will take time and enduring effort. "There is no public relations program that solves that problem in any short term,'' said Thomas James, executive chairman of adviser Raymond James Financial.
Indeed, said Hodge, "once lost, financial trust, like any trust is hard to restore.
"But it's not impossible."