Cockiness leads to vulnerability

By DAVID MOON, Moon Capital Management
December 26, 2004

It doesn't take much success to go to some people's heads. Or to get into the pocketbooks of others.

Unless something horrible happens this week, it appears that the S&P 500 is going to generate a single digit gain for 2004. Following a 28 percent gain in 2003, it would be easy for some folks to throw out their chests and get a bit cocky. Overconfidence leads to vulnerability. Vultures and other preying animals can smell vulnerability. Emotional or financial vulnerability is no different. The vultures will find you.

Earlier this month, the National Association of Securities Dealers (NASD) announced an investigation into whether or not some stockbrokers were inappropriately advising customers to borrow money against their houses to invest in the stock market.

It is painful to watch someone simultaneously lose their memory and risk their money. This sounds like a repeat of the late 1990s.

Rather than make a $15,000 cash down payment to purchase a home, a homebuyer might pledge the $30,000 worth of securities in his brokerage account as additional collateral to purchase a $200,000 home. His brokerage firm would then loan him the full $200,000 purchase price, taking a lien against both the house and the $30,000 investment account. If stock prices continue to increase without any intermittent declines, everything is fine. But if the value of the collateral stock account declines significantly, the broker/lender would require that the borrower/customer put more assets in the investment account, or risk a foreclosure on his home.

This isn't an uncommon gambit. The Federal Reserve Board recently determined that 11 percent of the proceeds from all mortgage refinancing is invested in financial assets.

The lines between stockbrokers, banks and insurance companies are more blurred every day; in a practical sense, they hardly exist at all. For the effective operation of a perfectly free market, those lines of distinction should have never existed. But in a perfectly free market, consumers are educated and knowledgeable. For reasons that are beyond the scope of this column, people generally know a lot more about tires and groceries than they do financial products and services. As a result, Wal-Mart is a bit more successful ' from the customers' perspective - at horizontal retail integration than are the large financial firms. The financial products that can be commoditized don't require a consultant for the selling process. You don't need a personal shopper to buy a skillet at Wal-Mart. But complicated financial products can't be sold as commodities. And they shouldn't be sold in the dark, either by unscrupulous or uneducated promoters.

I wouldn't expect much to come from the NASD inquiry. The NASD is a self-regulatory organization. It is the chief of the foxes watching over a henhouse full of brokerage customers. A handful of the more unruly foxes will be hunted down and shot as a public sacrifice. But without significant publicity, there will be few other consequences - for the brokers, that is, not their customers.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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