The Big Dangers of Small Print
Posted on April 7, 2011
Filed Under Investor Mistakes, Mutual Funds, Personal Investing, The Economic Scene
Can the economic collapse of 2008-09 be blamed on small print? I think the evidence supports that idea.
In October 2008, as the Great Recession was in full bloom, CBS’s 60 Minutes went searching for the causes of the calamity. They reported, among other things, that deep within the swirling mortgage mess were credit default swaps. If you wanted to know what those were, no problem. All you needed to do was to read through the hefty prospectus. Reporter Steve Kroft spoke with Frank Partnoy, a man whose résumé includes stints as a derivatives broker, corporate securities attorney, professor of law. Holding a credit default swap prospectus in his hands, Partnoy said, “It’s hundreds and hundreds of pages of very small print.”
Small print. Who does it benefit? Almost always, the answer is – not you, the end user.
My distaste for small print runs deep. Early in my career as writer of a mutual fund newsletter, I felt it was necessary to understand everything in fund prospectuses. Despite having a couple of college degrees, it was hopeless. The legal jargon overwhelmed me. Today, thankfully, most fund companies have attempted to replace jargon with plain English. Nonetheless, full prospectuses remain dense.*
In the case of the credit default swaps, 60 Minutes reported:
These complex financial instruments were actually designed by mathematicians and physicists, who used algorithms and computer models to reconstitute the unreliable loans in a way that was supposed to eliminate most of the risk.
“Obviously they turned out to be wrong,” Partnoy says.
Later in the interview Partnoy tells Kroft that the credit default swaps, “… were the centerpiece (of the financial disaster) really. That’s why the banks lost all the money.”
Clearly, small print and rivers of footnotes and disclaimers in those documents, and in the now-discredited “liar loan” mortgages, played a major role in sending the economy and the stock market into a tail spin.
Mortgages, annuities and other types of insurance products, and certainly most investment products have small print, and it behooves every investor to avoid stepping into the quicksand of a misunderstood document.
How to do that? Let me propose a rule of thumb; you can see it in a particularly pungent quote from former SEC Chairman Arthur Levitt, who a few days ago wrote in the Wall Street Journal, “Generally, one could predict that the more documentation necessary to explain an investment, the more likely it was to fail.”
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*There are two kinds of prospectuses: (1) the statutory prospectus; and (2) the Summary Prospectus. The statutory prospectus is the traditional, long-form prospectus with which most mutual fund investors are familiar. The Summary Prospectus, which is used by many funds, is just a few pages long and contains key information about a fund.
Sources:
http://www.cbsnews.com/stories/2008/10/05/60minutes/main4502454.shtml?tag=mncol;lst;4
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