"The Subtle Influence: Conflicts of Interest in Financial Planning by Frank C. Bearden, Ph. D. is a book that will change your financial advising practice. It will ease your mind, lower your level of stress and better prepare you for whatever the regulators choose to impose on financial advisors. You will be a better, more confident advisor.

This book should be read and absorbed by all advisors, RIAs, Registered Representatives, Broker/Dealers and all of those charged with providing unconflicted advice and professional judgment. It brings the sometimes elusive concept of fiduciary into something to which we all can strive."

-Ben G. Baldwin, CFP(R), ChFC, CLU, MSM, MSFS Noted Author, Speaker, Educator

Through detailed case studies, you will determine how to evaluate and respond to conflicts of interest so that your integrity is never called into question. Discover practical solutions that you can implement right away.

Conflicts of interest continue to wreck the careers of many professionals, and they also contributed to the recent financial crisis that devastated so many individuals and companies. Ensure that you survive and succeed with The Subtle Influence: Conflicts of Interest in Financial Planning.

"Conflicts of interest are a core component of discussions regarding client-planner relationships and fiduciary responsibility in the financial services industry. Dr. Bearden discusses such conflicts in a clear, straightforward manner, and his usage of client scenarios effectively adds color to ethical gray areas. Dr. Bearden's book is required reading for those advisors who aspire to maintain long-lasting client relationships and who want to interact with clients in a transparent, ethical, and mutually productive manner."

-Dr. Jesse B. Arman, ChFC, Vice President, Academic Affairs College for Financial Planning

The Subtle Influence

Conflicts of Interest in Financial PlanningBy FRANK C. BEARDEN

iUniverse, Inc.

Copyright © 2010 Frank C. Bearden, PhD.
All right reserved.
ISBN: 978-1-4502-3338-5

Contents

Preface...........................................................................viiChapter 1 Introduction: Are Conflicts of Interest a Big Deal?.....................1Chapter 2 Serving Up Damage to Professional Judgment..............................23Chapter 3 What Happened?..........................................................37Chapter 4 Naming the Problem......................................................48Chapter 5 Conflicts That Are Not Conflicts Of Interest............................63Chapter 6 The Appearance of a Conflict of Interest................................77Chapter 7 Conflicts of Interests Outside Of Practice..............................88Chapter 8 Conflicts of Interests within Practice..................................106Chapter 9 Indications of Their Presence...........................................125Chapter 10 Remedies...............................................................138Chapter 11 Suggestions on Practice Policy.........................................154References........................................................................159Index.............................................................................171

Chapter One

Introduction: Are Conflicts of Interest a Big Deal?

Conflicts of Interest in General

As this introduction is being written in early June of 2009, the United States is slowly emerging from what has been termed by Jack Healy in the New York Times as "the worst financial crisis since the Great Depression" (Healy, June 4, 2009). The analytical work as to the reasons for the crisis is still in process, but some of the broad contributing factors are assumed to be the issuance of large numbers of subprime mortgages, the drop in housing prices, defaults and foreclosures of the mortgages, and the run on capital for commercial and investment banks and other large financial institutions, not necessarily in that order. Because a significant part of the damage can be attributed to the general subject of this book (Strier, 2008), the event seems an appropriate place to begin a discussion of conflicts of interest. What follows is a discussion of some of the more significant factors at work in what occurred, to uncover the subtle role played by a major conflict of interest.

The Subprime Mortgage Crisis Sold and resold.

In the recent past, subprime mortgages in the U.S. began being issued on a large scale to persons with low credit scores, little credit history, or other credit impairments. In 1996, $96.8 billion of subprime mortgages were originated and in 2006 the total rose to approximately $600 billion (Coval, Jurek, & Stafford, 2009). The issuing organizations of subprime mortgages sold these loans to investment banking firms to receive fresh capital to lend again. The investment bankers then structured these loans into what can be loosely categorized as collateralized debt obligations or CDOs, to sell to institutional investors such as commercial and investment banks, hedge funds, pension plans, and insurance companies. The investment banks sought ratings on credit quality by credit rating services such as Moody's, Standard & Poors, and Fitch to facilitate the sales. The rating services were paid for their work by the investment bankers. The rating services also regularly provided these CDOs with high level, investment grade ratings that reflected little default risk, similar to the ratings for high quality bonds (Strier, 2008). Between 2005 and 2007, approximately 80 percent of the subprime mortgages were in CDOs given AAA ratings (Kim, 2008).

In fact, the subprime mortgages that were a major part of the collateral in the CDOs were of low credit quality (Coval, Jurek, & Stafford, 2009). The default rate for CDOs with investment grade ratings was significantly higher than that for similar ratings given to corporate bonds. Corporate bonds receiving Moody's lowest investment grade rating of Baa between 1983 and 2005 had a default rate over 5 year periods of 2.2 percent, while CDOs for the same period defaulted at a rate of 24 percent (Calomiris & Mason, August 24, 2007).

Highly rated CDOs had a distinct advantage over similarly rated bonds in that they had higher rates of return (David & Goldstein, June 18, 2007) which was a primary reason for their popularity. In 2006 the issuance of CDOs in the United States was $312 billion, a 102 percent increase from 2005, also a record year (Thompson, Callahan, O'Toole, & Rajendra, 2007). Had the CDOs been rated as somewhat speculative, their placement with institutional investors would have been on a much lower scale.

As CDOs grew in popularity, the revenue generated by credit rating services in their work with investment bankers grew significantly. Moody's revenue for the fourth quarter of 2007 rose 86 percent, and revenue for the year rose 24 percent. CDOs accounted for 44 percent of the revenue (Strier, 2008). In addition, credit rating organizations also provided consulting services to the investment bankers for the CDOs they later rated. These services included how to structure the debt products to receive higher ratings. Consulting on CDO type products accounted for 40 percent of Moody's revenue in 2006 (Levitt, Sept. 7, 2007).

Defaults begin.

With CDOs backed by subprime mortgages in place on a large scale in the portfolios of large commercial and investment banks, insurance companies, and hedge funds, the subprime mortgages began to default. The defaults occurred due to the interaction of a few distinct factors. A good place to begin reviewing these factors is with the characteristics of subprime loans. The structure of subprime loans was a major contributor to rising defaults. The majority of subprime mortgages originated from 2003-2007 were designed with a fixed rate of interest for two or three years and then an adjustable rate tied to a measure of market interest rates. These were known as short-term hybrids. Typically interest rates rose two or more percentage points after the initial period. Through mid-year of 2008, delinquencies on adjustable-rate mortgages rose to over 29 percent, while fixed-rate mortgage rates rose to 9 percent (Mayer, Pence, & Sherlund, 2009).

Lowered standards of credit worthiness also were a significant contributor to defaults. Median loan-to-value ratios increased from 90 percent in 2003 to 100 percent for originations in 2005 and 2007. Subprime loans with a second lien increased from 7 percent in 2003 to 28 percent in 2006. Subprime loans with the highest loan-to-value ratios at origination from 2005-2007 had the highest rates of default. Loans with little or no documentation of income or assets also contributed to the rising default rate. These subprime loans increased from 32 percent of the subprime loans originated in 2003 to 38 percent in 2007. From 2003 to 2008 serious delinquencies of subprime loans with little or no documentation rose from 5 percent to over 25 percent, while fully documented loans rose from 5 percent to approximately 20 percent (Mayer, Pence, & Sherlund, 2009).

The combination of subprime mortgages structured with adjustable rates and lowered credit worthy standards produced a loan portfolio with inherent vulnerability to changes in the larger economy. Two such economic changes that brought out this vulnerability in...