Smart investors have to wonder who’s dumb now

EVERY time financial markets become unhinged, there are calls to protect investors. Twenty-one years ago this October, global stock markets crashed, dragging down investors who had been persuaded to buy shares in companies they had never heard of, with names they couldn’t pronounce, engaged in businesses they didn't comprehend and located in places they couldn't find on a map. It’s no different this time — except that the acronyms have changed, the losses are bigger and the investments more complicated. On August 6, the Counterparty Risk Management Policy Group III — a 16-person private-sector initiative representing major investment and commercial banks, moneymanagement companies and a top law firm — released a 176-page report aimed at reducing risk and ultimately making the financial system more efficient. It includes measures to better understand and manage risky, complex securities. “The policy group strongly recommends that high-risk, complex financial instruments should be sold only to sophisticated investors,” reads the report. That raises the question of what constitutes a sophisticated investor. The group’s goal is to complement official oversight in encouraging industry practices that will help mitigate systemic risk. The report, “Containing Systemic Risk: The Road to Reform,” contains many good proposals. But when it comes to listing some of the characteristics that might define a sophisticated investor, it comes up short. Sophisticated investors should be able to understand an instrument's risk and return characteristics and have the ability to price and run stress tests on a security, says the policy group, which is headed by E. Gerald Corrigan, a managing director at Goldman Sachs Group and former president of the Federal Reserve Bank of New York, and Douglas Flint, deputy head of global markets at HSBC Holdings Plc. Investors should also command the procedures, technology and internal controls needed to trade an instrument and manage the risks associated with it, the policy group says. Furthermore, they should be wealthy enough to be able to absorb potential losses. Authorisation to invest in complex, high-risk investments should come from the highest levels of management. UBS AG, Merrill Lynch, Citigroup, HSBC and Wachovia presumably satisfy these criteria and surely regard themselves as financially sophisticated. Yet they and other institutions worldwide have racked up $505.5 billion in losses and writedowns because of the mortgage meltdown. Given such a performance, the folks who steered clear of collateralized-debt obligations and similar instruments may be considered the more sophisticated, if only because they were smart enough to acknowledge what they didn't understand. The policy group also advocates that investment term sheets, a summary of a transaction's details, and offering memoranda carry “financial health” warnings displayed in bold print. Yet given the propensity with which smokers ignore health warnings on cigarette packages, there is no reason to assume that investors will be any different. In addition, the group calls for stronger relationships between financial intermediaries and counterparties in sales and marketing and ongoing communications relating to complex financial instruments. “The policy group believes there is a responsibility on the part of large integrated financial intermediaries to provide clients with timely and relevant information about a transaction,”