Ever since Congress and regulators failed to fix the sales incentives that drove us to the epic global meltdown of 2008, I’ve been watching for the next debacle — and I think it’s finally coming into view.

If I’m right, we’re approaching a confluence of failures that will feed on each other. The next great debacle will end up tarnishing (yet again) Wall Street’s reputation. But this time I’m afraid it will also stain the good name of financial planners and advisors.

Let’s start with nontraded REITs, which seem to be imploding right before our eyes. I warned anybody who would listen about recommending opaque illiquid products that use investor dollars to pay huge commissions and generous due diligence fees to broker-dealers.

How could anybody believe that this toxic combination adds up to a viable investment? Unless, of course, the promoter is stuffing money in your shirt pocket.

Now broker-dealers, custodians and investors have all started to back away from the sector; I suspect the stench has become so awful that they have, somewhat belatedly, gotten cautious about taking on the liability associated with selling at least some of this junk.

They may be remembering a lesson we all learned in the last go-around with investments like these, during the tax shelter era. The general partner business model for illiquid investments is only sustainable if ever-greater amounts of money are being raised. Once the sales dry up, the sponsors pack their bags and move on to the next opportunity — or retire in luxury with millions of dollars sucked right out of the accounts of workers and retirees.

If I’m right, the next great debacle will see thousands of customers — who put their trust in people who call themselves financial planners and investment advisors — discover that they can no longer afford retirement. The lawsuits over billions of lost investor dollars will, once again, test the viability of the independent broker-dealer industry. Headlines will paint the entire financial planning profession as a bunch of greedy sales agents.

YIELD-BASED APPEAL

Nontraded REITs are sold as a high-yield investment in a yield-starved marketplace. Using essentially the same pitch, a growing number of reps are also selling load-bearing fixed-income mutual funds that offer impressively higher yields than their peers.

Their secret? Load up on the diciest (unrated) private bond issues, BBB-rated or lower investments and higher-duration bonds that are going to get creamed when interest rates tick up.

The Fed has kept rates so low for so long that thousands of questionable issuers have been able to float bonds and rake in money at above-market rates that are low by historical standards. Since the Lehman Brothers collapse, aggregate corporate bond debt has increased an astonishing 53%, according to Bank of America-Merrill Lynch research, with three straight record $3 trillion years of new paper issued. 

And emerging market countries set a record for debt issuance last year, at more than three times 2006 levels, according to Thomson Reuters. Kenya issued the largest sovereign bond issue ever by an African nation, equivalent to about a third of its total tax revenues — and the offering was four times oversubscribed.

This is looking like a bond bubble of epic proportions, as the potential default of some Puerto Rican bonds — a prominent holding of many of these yield-chasing funds — is starting to make clear. Any reasonable due diligence effort would question whether Puerto Rico will ever be able to pay back outstanding municipal debt that equals $18,919 per resident of that impoverished island.

Yet last year, an article in The Bond Buyer noted that a Franklin Templeton fund had amassed an astonishing 61% weighting in Puerto Rican debt, while a number of Oppenheimer funds were more than 20% invested in Puerto Rican bonds.

BOND CRASH AHEAD?

It’s not hard to predict that, early in the next great debacle, interest rates will tick up just enough that nobody on the secondary market is going to want to buy dicy paper when they can get equivalent yields from new-issue Treasuries. At current rates, even small shifts could cause risky bond values to fall hard enough to startle lay investors.

Millions of people could see losses on their quarterly statements in a part of a portfolio that their sales rep, masquerading as a financial planner, told them was rock-solid stable — and many of them are going to want to redeem their shares. A run-on-the-bank phenomenon would make the liquidity problem much, much worse.

Imagine the panic reaction if word gets out that certain funds are unable to liquidate and give investors their money back.

I’m going to go out on a limb and predict that at least some of these funds will decide to calculate their NAV using optimistic valuations for bonds that nobody wants at any price. When the regulators step in and demand a repricing, and investors see dramatically higher losses than were being reported, the whole downward spiral will go around one more turn.

In a related scandal, policyholders might discover that the universal life contracts they were sold are nowhere near performing as they were projected when these sales reps sold them the policies. As insurance companies demand new premium payments to keep the policies in force, and investors complain about double-digit losses in their bond funds, the media will have yet another reason to question the value of a financial planning engagement.

ANOTHER BIG SHOE

Somewhere in this mess, I expect another big shoe to drop. Does anybody want to bet that the wirehouses are not selling trillions of dollars worth of undisclosed, unregulated derivatives contracts that allow companies and banks to hedge against higher interest rates?

If rates jump faster than their models predict, I can envision Wall Street firms being on the hook for more than their aggregate net capital holdings — and, given the size of the derivatives market, the liability might actually be comparable to gross global GDP.

I wouldn’t be surprised if, as the next great debacle unfolds, we were to discover that the brokerage firms had also been quietly selling packaged combinations of privately issued bonds to their institutional and highly leveraged hedge fund customers — junk disguised as high-quality paper.

Welcome to the next government bailout.

I hope none of this comes to pass; I really do. But I think the next great debacle that I’ve outlined here is a grimly logical consequence of all the sales incentives that still govern so much of the financial services marketplace. It’s a shadowy world where what you make is infinitely more important than what the customer makes.

Unless those incentives are fixed — and unless the public is given a fair chance to know who is and who is not motivated to sell them junk investments — we’re going to see this same unhappy scenario play out over and over again. The particular investments and shady scams may change from debacle to debacle, but the underlying driver remains the same.

As the next great debacle unfolds, I would ask that both regulators and journalists pay close attention to the fact that those who could trigger this multiheaded scandal — ruining millions of financial lives with self-serving recommendations — were allowed to call themselves financial planners and financial advisors. But that doesn’t mean that they actually were.

Bob Veres, a Financial Planning columnist in San Diego, is publisher of Inside Information, an information service for financial advisors. Follow him on Twitter at @BobVeres.

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