ERROLD F. MOODY JR.

July 8, 2006

Federal Chairman Ben Bernanke

Board of Governors

20th St and Constitution Ave NW

Washington, DC 20551

RE: Consumer financial education

Dear Dr. Bernanke,

I read with interest your comments a month or so ago about educating the public about finances. It is an absolute requirement that they grasp some of the fundamentals not only for investing purposes but, perhaps most importantly, to avoid many of the problems and mishaps of the uneducated. That has been most evident during 2000- 2002 and the loss of retirement assets (if they had that much to begin with).

Additionally, your comment, "clear disclosures, wise regulation and vigorous enforcement are essential to ensuring that financial service providers do not engage in unfair or deceptive practices" is well intentioned and certainly necessary.

Unfortunately, the end result will be effectively little better than the current condition. And the reason why is that the supposed educated practitioners (brokers, planners, agents, et al) have never been taught the fundamentals of investing. They have never been tested; therefore never been offered as part of licensing training; therefore not offered for continuing education; therefore not provided in work with consumers. And if the government has deemed it unnecessary to educate the "professionals", one cannot look to save the public. It just won't happen: the unknowledgeable will simply thwart any attempt at making a consumer ask more exacting questions- and hence slow sales. As far as enforcement- the various state and national departments are understaffed and underfunded. But it is more than that- I have had direct contact with several states, they are also under "knowledged". They might be able to help seniors and a few others with simplistic and obvious cases. But once you hit a more intertwined fraud, they cannot do the work. The SEC has all sorts of inspections- but they are of areas superfluous to suitability.

In order for any intensive effort to succeed, it is necessary to understand risk. In order to understand risk, it is first necessary to understand diversification. If you cannot get these right, you cannot get to suitability.

In order to put this into real life perspective, allow me to provide some of my background (the resume is included). Over the years, I have taught almost all subject areas in finance to all types of personnel. Such has included literally all the securities licenses (4, 6, 7, 8, 24, 27, 52, 63 etc.). Almost everyone (including journalists- though that isn't saying much) have assumed that a broker has a defined knowledge of risk and reward. That is not true and has never been true. Beta, alpha, diversification, correlation, standard deviation, asset allocation- effectively most of the areas identifying and analyzing what a consumer should do and why given a certain scenario- have never been tested. Hence they are not taught. And while there is mandatory continuing education for practitioners, most is a rehash of simplistic positions that are seldom indepth. The series 7 is a one week course at all securities licensing firms. That's it. It is. Practitioners are simply not going to get anything on true suitability of products. And all sales MUST be suitable.

Diversification

Diversification is the first level to an understanding or risk. It is not the fuzzy, "don't put all your eggs in one basket" since it has no statistical merit or use in suitability. It is mandatory that one know the definition to diversification by the numbers. (How many stocks do you have to have in a portfolio in order to insulate from unsystematic risk? More colloquially, how many stocks do you have to have in a portfolio? At least 50. (See article by John Y. Campbell , Martin Lettau, Burton G. Malkiel and Yexiao Xu:  This paper uses a disaggregated approach to study the volatility of common stocks at the market, industry, and firm levels. Over the period from 1962 to 1997 there has been a noticeable increase in firm-level volatility relative to market volatility. Other studies suggest from 100 to as many as 350 stocks.) If you do not know that, you are clueless to risk. But, allow the latitude at this point- I doubt anyone at the SEC or NASD has a clue. Past SEC chairman, Chuck Levitt, described diversification in his book as the ‘eggs basket' routine. I do not dismiss his ability to run the SEC- but I do take exception with sophomoric homilies to consumers that aggravate an already abysmal understanding of risk and reward. When I approached the NASD over 10 years about education for arbitrators they replied that the industry would never allow it since it would slow sales (quite true). (As a past arbitrator, it was patently clear that the panel was woefully ignorant of any of the fundamentals.) Most recently, they simply stated that the NASD is a procedural entity, not a substantive one, and that any insight to the fundamentals/suitability had to be provided by the attorneys. Really??!! I have never met any securities attorney who knew what diversification was. I only met two who wanted to know when approached in a case. I am not stating that arbitrations and court cases are all bad because the participants are untrained and unknowledgeable, but somewhere along the line, the plaintiffs and defendants have to have some idea what the issues are beyond the fact that someone was old; they were "sophisticated" (they should all be ashamed for their abhorrent presentations about sophistication) and bringing in reams and reams of papers and numbers that tend to obfuscate the case rather than deal with the realities. The experts may be better- but they also tend to come from the ranks of the brokerage houses- and no insight to suitability has been taught to them either. It is useless to discuss a case when the fundamental application of securities, insurance, etc. cannot be addressed.

Risk

Risk and suitability are nebulous terms to the unsophisticated, the unknowing and, particularly, the intended unread. Frankly it is a sad commentary that those supposedly in the know are so blatantly- and unapologetically- ignorant of beta, alpha, diversification, monte carlo and more. Standard deviation is generally presented as risk- but it is not. It is one form of risk among many- financial, emotional, business, interest rates ad infinitum. Further standard deviation is almost wrongly applied- it does go down over time but the risk of loss of money goes up. I defy anyone to look at almost any financial plan and not see the flawed statistical analysis and the intent to deceive the public into a purchase of a product(s) that will never work as projected.

Suitability

It is not, obviously, just standard deviation that needs to be addressed- there is still the data of beta, alpha, correlation and much, much more. A consumer must be provided the essence of this knowledge to rationally analyze the risks and rewards when a product or service is offered. How are you going to get the consumer updated on this- and the exponential increase of new products- if no one has even bothered to do anything with the supposed professional. No wonder suitability is never defined in any manner other than some superficial rhetoric- the parties throughout are clueless to what has been needed for decades.

As examples of cluelessness, variable annuities and variable life can still be projected at a 12% annualized return. The risk inside these is horrendous since there is no way they can attain that on a regular basis. And the government sits around wondering why so many consumers then end up with far less than they thought. Index annuities have been around for 10 years- but only recently has the infighting as to whether it is an insurance product or a security softened so that the regulators would do something. Kind of late for many consumers who were clueless and victimized.

Advanced Knowledge (?)

As to the designations that suggest competency (CFA, CFP, ChFC ad infinitum), most are superficial at best with minimum study time or standards. For example, the main designation in the planning industry- the Certified Financial Planner- is the same as one semester on money. I have been a CFP for over 22 years. It certainly exposed me to areas I probably would not have explored otherwise. But that is pretty much all it did- provide an insight to a number of areas with very limited indepth competency. Many pundits will view that as heresy since they state that the coursework is the best that the industry provides since it requires a single 10 hour exam. Because we both have paid our dues, every single college course I have had required a three hour final exam. At least 15 credit hours per semester; hence 15 hours worth of exams at a minimum per semester. The CFP and the corresponding ChFC (Chartered Financial Consultant) do have value in that they are better than no designation. But the CFP coursework still does not encompass the true element of risk. Standard deviation is incomplete. A 2004 ‘graduate' noted that he did not have to learn anything about diversification. As an industry leader noted, "There are 141 topics in the CFP investment education module, and not one of them addresses how to find the best portfolio for your future dollar goals."

I have also acted as an expert on various investment and retirement cases- including those by CFPs and the associated firms, Harvard MBAs and the like. They just use software programs using old data (effectively all data is old since it takes about a year to gather statistics) along with justification of selected verses of past analysis of the efficient frontier, Markowitz studies, numbers developed over 100s of years with the ending proviso that you can buy and hold (save for yearly rebalancing) forever and so on. No intellectual modeling, no thinking.

A 2005 case against American Express clearly showed the lack of knowledge of risk.- and this from a giant in the industry saying you should trust your money to them. They did provide elements of standard deviation and it sure ‘looked good' to the novice. But they only provided the positive element of risk (standard deviation goes down over time) that looked good to sell a product or service. They did not include the part that made the risk scenario unacceptable (risk of loss goes up over time). Incompetency? Absolutely. Outright Fraud? Probably due to their fiduciary obligation to know what they were doing. On the other hand, I don't think American Express or the CFP adviser had a clue to material they had to include. It's not taught. (Case was settled for client's favor)

A current case involving a defined benefit plan for over 250 fire departments in New York shows deficits at a minimum of $100 million to perhaps $250 million. Not a single commissioner or officer had a clue to what to look for- though some were lazy in not addressing what was obvious in annual reports. But it is no wonder that so many municipalities and governments are so deep into deficit on health care, pension funding and most every other areas of finance. What governmental guidelines were provided on which they could look at the proposals objectively? None.

Another Florida case involved a major CFP who coughed up a $300,000 settlement agreement in arbitration (refused to pay) but had been exonerated in full by the CFP Board of Standards (including corruption by Board officers). I have submitted a detailed report it to the Florida Department of Financial Services for a formal investigation. They are issuing subpoenas for all his files.

An arbitration board stated to the plaintiff's attorney that they didn't have to hear my comments about industry practice since they had an industry supervisor on the panel. But they were clueless (including the securities arbitrator) since supervisors have never been taught the fundamentals of investing either. There is nothing in the Series 24 on suitability, proper application, standard deviation, historical statistics. Nothing. They don't know that they don't know.

An unsophisticated elderly neighbor went to a bank with proceeds of a real estate sale and was led into an annuity where the surrender charge was longer than his actuarial lifetime. The consumer had no idea what his lifetime was. The salesperson probably did not either since this material is not part of basic education - but the sale should have been evident as a breach of duty (could it have been the $8,000 of commissions?).

Even basic education is going to be far from adequate. The education and demands for the professionals is inadequate. Here is a major key point of my commentary. How can anyone state that they know money if they cannot use a financial calculator? They can't. Impossible for any financial practitioner to do anything with money- investing, insurance, annuities, counseling, real estate- without the personal functional capability of doing basic PV and FV (actually it is more than that, but I am already asking for too much.) (Give Securities and Exchange Commission Chairman Christopher Cox a PV, FV problem. Bet you can't get an answer). We both know that consumers will never master PV, FV etc. Yet is it not important to educate consumers that they at least ought to find someone who knows how money works? Cox stated that "Consumers with the necessary skills to make informed financial decisions about buying a home, financing an education or their retirement or starting a business will almost certainly be economically better off than those lacking those vital skills." Agreed- but if the advisers cannot- and are not required to know to- use a financial calculator, how well served are the consumers? The vital components are knowledge and real life application. It is not the rhetoric of an industry essentially divested of real life capability. Sure they can provide some valid info. A janitor in a hospital can legitimately and validly tell an obese patient to ‘lose weight'. That does not make practitioner any more acceptable in dealing with more involved matters.

Cox did say- and I agree- that "It is not our job to tell people how they should invest," But the point is that the SEC is fully aware that it has never provided information to even industry practitioners about the fundamentals of investing or insurance (trust me- insurance is far harder to grasp than investing). It "knows" they are unprepared to establish proper risk guidelines for the consumer. (Ask him if he knows what diversification is at the elemental level. Bet you won't get a good answer.) Literally all governmental entities know- or should know- that the public does not have the capability to grasp a prospectus or annual report- certainly the nuances of a footnote. The implication allowed that the bulk of those trained under SEC and the NASD and associated agencies have a clue is a farce.

"Putting them in the driver's seat means giving ordinary investors the means to interact directly with companies' information in a way that allows them to compare, contrast and put that information into contexts that are meaningful to them." If you do not understand diversification by the numbers, you cannot determine risk. If you cannot determine risk, you cannot determine suitability. Period. The idea that one might be able to interpolate one annual report is a stretch. The ludicrousness of the effort is that putting someone in the driver's seat for one company analysis begs the issue that they are going to be able to it a minimum of 49 more times in order to be diversified is absurd. I may be able to analyze one, two or three companies decently given my schedule- but to try and do a minimum of 50 in various industries belies common sense- even uncommon sense.

Admittedly there was further commentary- ‘Even armed with an outstanding financial education, "very few investors are able to slog through the swamp of legalese" known as corporate annual reports and mutual fund prospectuses.' Well, duh! Cox said the SEC would like to see such financial disclosures written more clearly so they are easier to understand. Easier?? If the SEC and NASD officers, directors, attorneys et al do not know diversification by the numbers, do not have the capability with basic financial calculators, cannot explain recapture of depreciation, then the focus to fundamental consumer knowledge, while unquestionably needed, never has any true substance. And for what purpose? First and foremost one needs to tell consumers just how many stocks they will NEED to analyze- anything less is a breach of suitability standards. Anything less is a breach of fiduciary duty.

Intervention/enforcement

Vigorous enforcement is a nice thought but the budgets for insurance and securities departments have been going down for years. Regulators do go after the most egregious of problems but are so far behind the curve of new products and regulations that the average consumer is out of luck for general incompetency. The industry overall needs to step up to assure the duty to consumers for the proper product and service is offered. But they won't do it. Because they are inherently incompetent- and additionally aware that such knowledge would severely reduce the sales of products and service. This will continue unabated because the government at all areas has never required competency. In fact, the general level of knowledge and application is going backwards.

This commentary was not meant as a tirade against brokers, agents and others involved in the industry. But it just as easily could be since they act as fiduciaries with consumers (though I am aware of the defense in certain areas). Until the government makes a concerted effort to demand a solid knowledge base of its practitioners, the economic debacle of 2000- 2002 will be repeated quite soon; the ability of the next Lay and Skilling to commit fraud and deception will be little dimmed and the retirees will become more and more destitute. Additionally, the sophistication of products and processes is growing exponentially. I have taught many continuing education courses for insurance agents and securities reps- they are not keeping up. I suppose they might only have to be competent in one area- but that seems to negate the absolute intertwining of the many areas of personal finances. The consumer is pretty much out to lunch. Yes, there is the occasional article in Smart Money, Kiplingers et al that provide some valid insight but how is the consumer to know which part is good and which is not. (For the record, I tend to find the articles to be 75% to, at the extreme, 90% correct. But being 10% to 25% wrong almost all the time is nothing to brag about and tends to screw up the entire focus of the article.) If your comment was to engage the public with ‘what is a savings account; why credit cards can be bad for your financial health, etc.' then I most certainly agree that these are compulsory topics for high school and college and can be offered with relative ease and success. But if your focus was to get consumers another step up in their understanding of annuities, stocks (company analysis??), life insurance, et al, you are going to have to offer more than words since the current practices by the industry have been and continue to be bereft of competency/knowledge/practical application. This area has to be cleaned up if any success with consumers is to be reached.

In short, if you do not know what diversification is by the numbers, you cannot determine risk. If you cannot determine risk, you cannot determine suitability. The consumers should have this knowledge and understanding before undertaking a purchase of a service or product. The practitioner has a mandatory obligation to know and apply the real life application.

Very Truly,

Errold F. Moody Jr.

Enclosure: Investment Malfeasance and Breach of Fiduciary Duty.

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