Money Making Schemes

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Recently, I had a discussion with a client who marveled at the ability of Wall Street firms to make money. He assumed, like many other investors do, that many high powered firms have superior stock picking abilities or staff with the foresight to properly assess the next hot investment trend so that the firm can get in on the bottom.

Generally speaking, that’s not how the money is being made. Sure, being in on worthwhile IPOs will always generate large sums of money, but even more is being made (and lost) in the derivatives business.

While I will elaborate on that further with a special post within the next couple of weeks, I was reminded of it when I read the latest fraud investigation on Mish’s Global Economic blog titled “Fraud, Antitrust Investigation Involving JPMorgan, Jefferson County.”

It’s a stark reminder that all is well and good on Wall Street, and the events of the Orange County bankruptcy in the 90s (due to derivative investments) have been long forgotten.

Here’s an excerpt of the latest derivatives debacle:

The Largest U.S. Municipal Bankruptcy Looms in Alabama. What caused this mess is an interest rate swap Jefferson County officials entered into when they financed a $3.2 billion sewer cleanup. The strategy backfired, demonstrating the speculative, risky nature of swaps.

Like homeowners who took out mortgages they couldn’t afford and didn’t understand, Jefferson County officials rejected fixed- rate debt and borrowed instead at rates that varied with the market.

The county paid banks $120 million in fees — six times the prevailing rate — for $5.8 billion in interest-rate swaps. That was supposed to protect the county from rising rates for their bonds. Lending rates went the wrong way, putting the county $277 million deeper into debt.

That means local officials now have to pay to banks money that otherwise might have been used to build schools, hospitals or public housing.

Meanwhile, the U.S. Securities and Exchange Commission and the Justice Department are now investigating bankers and officials involved in Jefferson County’s swap agreements.

[emphasis added]

It pays for you to read the entire story, but suffice it to say, that’s the way big money is being made—not by trying to pick the next hot stock. The eventual outcome of this debacle will be the same as always: A few heads will roll, some fines will be paid but, afterwards, it’s business as usual.

As for the rest of us, we have to take the hard road by investing responsibly and conservatively especially when other people’s money is involved. The markets don’t make this always easy, especially when we’re trending sideways; we have to tough it out and stick to our plan in order to succeed long-term.

While this route may not make my clients hundreds of millions of dollars, it let’s me sleep at night knowing that we work with integrity by never having to worry that we were part of a scheme that brought down an entire county.

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