Trust, but Verify.  The three most important words in investing.

By design, our financial system is suppose to ensure investors have access to all the information they need to make a fully informed investment decision.  This puts investors in the position where they can Trust the story told about an investment by Wall Street and use the disclosed information to Verify its truthfulness.

I said “suppose to” because frequently it doesn’t.

Why doesn’t it always ensure investors have access to all the information they need to know what they own?

Wall Street.  Wall Street knows it makes much more money selling high margin opaque products.  This gives it an incentive to limit the information disclosed.  Wall Street limits the information disclosed by capturing the process by which disclosure requirements are set.

Once Wall Street has captured the process, it is free to engage in its business model of fraud.  Wall Street know the lack of information means investors cannot Verify its story about the value of a security.

This business model of fraud is exemplified by subprime mortgage-backed securities.  First, Wall Street’s capture of the disclosure requirements process meant these securities were opaque.  Then, Wall Street loaded up these securities with toxic waste.  Finally, Wall Street represented these securities as far less risky than they actually were knowing investors could not verify this fact.

The following chart gives a sense for Wall Street’s willingness to misrepresent the quality of these securities: