Wall Street’s Favorite Trick

Wall Street and the rest of the financial services industry perform an important job putting idle capital to good use. Instead of piling up cash and earning nothing, we can earn money by loaning it to others or buying ownership in firms that may either grow or pay us dividends, or even both. Both investment banks and savings banks are what economists call intermediaries. They match people who have money to others who need money.

In exchange for that service, they either collect a fee or they make a profit from creating a product, such as an insurance policy, and selling it for more than what it cost to create. If an investment firm sells on behalf of a customer, it’s an agent. But if it owns a product it wants to sell, it’s a dealer. Most large firms act as both, which is why they’re often called broker-dealers.

If the firm is acting as an agent, its fee and commissions structures should be published, even if it takes some digging through a prospectus to find out what they are. And, thanks to that public scrutiny, they are dropping.

But the same isn’t always true when firms create their own products. There’s competition, but complex products — insurance policy riders and structured products can have some whopping costs built into them and can be tough to estimate. Here’s why dealers can get away with it and what you can do about it.

The House Always Wins

Firms can accept bigger risks than individuals can for two reasons: They have enough capital to sustain long losing streaks — and that’s fine, because that’s a source of economic strength — and they can price risk accurately and “neutralize” it by taking an opposite risk. Imagine if you had the choice of doubling all your money or losing it all on a single coin flip. Would you do it? Probably not; the odds say you shouldn’t care, but the conse­quences can be dire if you lose all your money. Now, would you do it if you could not only double your money, but also make an additional 5%? Again, most people wouldn’t.

A dealer would take that bet if it’s confident it could find someone willing to take the opposite side of that coin toss, which creates a “heads-I-win-and-tails-I-win” arrangement. The dealer pays the losing bet and receives the winnings, which would be 5% more than break-even. That’s called riskless arbitrage, and firms love it when they can make money with zero risk.

It’s easy to estimate the likelihood of winning a coin toss, but what about estimating how likely it is the stock market will be below where it is today in 10 years? That’s a little tougher, but if a firm can buy insurance against it that cheap then create a product that promises to pay at least break-even after 10 years and sell it for much more than it costs, it’ll do that in a heartbeat. The firm then sells those sorts of products to those who want to invest in the market but are afraid of losing money. The downside is that investors have limited upside.

Usually the terms are that, after a specified amount of time, the investors will get either the minimum of their money back, or some upside that depends on some arcane formula tied to the market but is usually quite a bit less than what the market itself would have paid. The dealer keeps an enormous profit after paying for the cheap guarantees, while you could have achieved something better simply by buying some zero-coupon bonds and a few shares of an S&P 500 tracking fund.

The Fear of Missing Out

With interest rates so low, it isn’t that attractive a play yet, but zero-coupon bonds allow you to buy $1,000 in the future for a discount. For example, if they were available, a zero-coupon bond at 5% would cost only $616.61, leaving you free to invest that other $383.39 into the market with no limitations on profit. So, if the market goes to zero, you will still have $1,000 at the end of 10 years. And chances are very good that not only will the market not go to zero, but it also will do better than break-even.

Wall Street’s favorite game is to play on investors’ fears and cater to investors’ greed. When the market is booming, firms rush out new stock offerings of medium- and low-quality companies. They are playing to the “fear of missing out.”

But when the market has been crushed, they offer assurances at very expensive costs. So when you’re offered a complicated product with assurances, ask yourself or someone you trust whether there is a less expensive or less complicated way of accomplishing the same thing.