Mexican Debacle Raises Questions on How Securities Are Marketed

With the Dec. 20 devaluation of the peso, those who had invested directly in Mexican securities or in professionally run Latin American funds and those whose pension plans contained some of these securities saw their investments lose 25% to 90% of their value in the course of a few weeks.

The Mexican debacle is worthy of attention because of its magnitude, but, even more so, because it raises serious questions about the way in which Wall Street brings securities to market and about the quality of its research.

In an interview on public television Feb. 21, Secretary of the Treasury Robert E. Rubin, the former co-chairman of Goldman Sachs, said of the Mexican financial crisis: “Nobody could have predicted it.” Nonsense. The fundamentals that led to the devaluation, together with glaring evidence of economic mismanagement, had existed for years, not months, before. A few of them are:

* Tensions created by huge, indecent, social inequalities. Under President Carlos Salinas de Gortari, these grew larger, not smaller.

* The existence--not only the possibility--of social unrest. Chiapas is but the tip of the iceberg. The Zapatista rebel movement antedates Salinas.

* The corruption, brutality, nepotism and incompetence that is firmly rooted in most of the Mexican ruling class.

* Potentially explosive divisions between the old and new guard within the PRI that are about to fully come to light with the Colosio and Ruiz Massieu investigations.

* A current account deficit that has ballooned since 1990 in what amounted to an unsustainable and illusory subsidy of living standards with short-term foreign debt.

* The disproportion between the influx of ‘hot,” highly volatile, foreign money and long-term foreign investment.

* A corrupt and undercapitalized banking system that is now teetering on the edge of collapse.

While these and other fundamentals may not have been known to the investing public, they always were a fact of life to people “in the know”--and certainly to Wall Street.

Goldman Sachs reportedly brought over $5 billion of Mexican securities to market in the three years preceding the Dec. 20 devaluation. The number for J.P. Morgan is $2 billion; for Bear Stearns $1.8 billion. Securities law requires that “due diligence” and “full disclosure” be carried out by underwriters when bringing securities to market. The idea is that every variable likely to have a material impact on an issuer’s business should be identified and fully communicated to prospective investors in a prospectus.

Taking an average prospectus for a Mexican issuer during the last 18 months or less, it is astounding to find that no reference whatsoever is made to the extreme fragility of the Mexican edifice as being potentially devastating to the issuer. These and other glaring omissions constitute the very antithesis of “full disclosure.”

The devaluation did not alter Mexico’s fundamentals; it merely exposed their weakness to the investing public, demonstrating that if the paper had been sold by the underwriters for the “junk” that it was, its issue price should have been substantially lower to reflect the risks involved.

Wall Street “analysts” (recently referred to by Barton Biggs, the Morgan Stanley prophet, as “smart young guys”), also deserve honorable mention. Almost unanimously, they sang the praises of Mexico until the very last minute. Less than three weeks before Dec. 20, Robert J. Pelosky Jr., Morgan Stanley’s head of Latin American research, effusively recommended Mexican investment. J.P. Morgan, Bear Stearns, Goldman Sachs, Smith Barney, Bankers Trust and others all joined in the chorus.

Yet at least as far back as the beginning of 1994, the International Monetary Fund, Treasury and CIA had noted a variety of technical factors indicating that Mexico was treading on increasingly thin ice. Why did Biggs’ “smart young guys” fail to do likewise? Deriving their remuneration from commissions paid by investors, many analysts and underwriters are paid in the mid- to high-six figures. Their seniors, the Biggses and Rubins, are paid in the millions. Why? What do these people bring to the table?

It is of the essence to ask how investors are to get reliable information on which to base their decisions in the future. Forget the Securities and Exchange Commission. This kind of abuse has existed with impunity for years. Besides, the SEC is probably too busy investigating the peddlers of derivatives (of Orange County fame), the same firms that peddled Mexican “junk.”

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The underwriting process contains a built-in conflict of interest in that underwriters only make money if they bring securities to market. Why not have due diligence and full disclosure carried out by a neutral third party, such as the big U.S. accounting firms, whose compensation would not be in the form of a “success fee”?

Likewise, analysts being paid by the same firms that both underwrite and trade the securities they follow is hardly conducive to impartiality. The same goes for economists attached to Wall Street firms.

“Chinese walls” are as much an illusion as the pre-devaluation image of Mexico. Thus, detaching these functions from Wall Street would eliminate the current bias toward orchestrated financial hype.