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Banks' bad behavior may be scaring away investors

It wasn't supposed to be like this.

After the worst financial crisis since the Great Depression almost took the global economy over a cliff, tough new regulations and stronger internal controls at the world's major banks were meant to help restore confidence in the financial system.

But recent headlines have some top investors and strategists questioning whether there has been any progress at all.

The horror stories include the deepening scandal that big banks rigged Libor, the benchmark international lending rate; JPMorgan Chase's mounting losses from disastrous credit bets and a possible cover-up attempt; and the disappearance of customer funds from Iowa futures broker PFGBest, discovered after its founder tried to commit suicide and left a note outlining a 20-year fraud.

Add in the problems surrounding the botched trading debut by Facebook as well as the insider trading scandal that led to the conviction of hedge fund managers and big name businessmen such as former Goldman Sachs director Rajat Gupta -- and the picture isn't pretty.

The signs of a falloff in investor confidence are not hard to spot.

U.S. Treasuries, the traditional safe-haven for risk-averse investors, are drawing big demand even though they offer only the slimmest of returns, while U.S. equity mutual funds have racked up big outflows.

And even though some of that investment trend may reflect the fragility of the U.S. economic recovery, the real problem lies elsewhere, said Larry Jeddeloh, founder and chief investment officer of the TIS Group, an institutional research firm that also manages client money.

"The bigger problem, which I think investors are focusing on, is confidence in the financial system is eroding," he said. "There have been a litany of failures and confidence-reducing events recently which should cause anyone with a stock certificate and a heartbeat to think hard about what to do with their stocks," he said.

For many small and even some big investors, the recent headline events create a perception that the system can be gamed -- and that they could lose money because those who are able to manipulate a rate or a stock price or have inside information wield a big advantage, investors and strategists say.

At worst, in cases like the failed brokerages MF Global and PFGBest -- with the echoes of the Bernie Madoff and Allen Stanford Ponzi scams also ringing in investors' ears -- it means that someone could simply raid their account and take their money.

It all feeds into a wider political backdrop. The speed with which the Occupy Wall Street movement gathered pace last year was seen by some economists and major investors as a growing symbol of the distrust of banks and the inability or unwillingness of the authorities to crack down on corporate malfeasance and greed.

Almost all of the scandals lead to allegations that regulators are asleep at the wheel or simply lack the firepower to keep up with the misbehavior.

In the scandal over the rigging of Libor -- the London interbank offered rate that influences interest rates around the world -- documents released last week showed that regulators on both sides of the Atlantic knew years ago that there was something very wrong with the system but they have done very little to try to fix it.

Jeffrey Lacker, president of the Richmond Federal Reserve Bank, said the Libor scandal is fueling public anger toward the banks. "The revelations broadly are another episode that is damaging to people's confidence in the financial services industry, and that's a shame," he said in an interview with Reuters last week.

In the case of PFGBest, its founder and sole owner, Russell Wasendorf Sr., confessed in a signed statement that he duped the National Futures Association, which had first-line responsibility for overseeing non-clearing brokers such as PFGBest, for up to two decades by forging bank documents.

The FBI arrested Wasendorf on Friday and accused him of stealing more than $100 million from clients.

Even so, investors sometimes still shake off fears and plunge back into risky assets.

On Friday, after JPMorgan revealed its trading losses could be as high as $7.5 billion and Reuters reported that federal criminal investigators are investigating whether JPMorgan employees in London hid the problem, its shares rose 6 percent and the U.S. stock market rallied. Among the reasons given by traders and investors: The worst of the scandal may be behind the bank.

"I am always surprised at the resiliency of the American investor and how people have become comfortably numb with each new scandal," said Frank Partnoy, a former derivatives trader who has written books on the instruments and a law professor at the University of San Diego.

The lack of confidence may not always be apparent in day-to-day trading but it is showing up in financial markets in a number of other ways.

Investors are mostly shying away from assets that carry high or even modest levels of risk and parking their money in U.S. Treasuries and other places that pay very low interest rates. The yield on the benchmark 10-year Treasury yield on Friday was at 1.49 percent, just a hair away from the record low of 1.46 percent touched in early June.

Cash balances at major companies remain at very high levels. Those trends are occurring even though the world's major central banks, led by the Fed, have found innovative ways to create easy monetary policies in an attempt to get companies and consumers to spend.

According to Jeff Tjornehoj, head of Lipper Americas Research, U.S. equity mutual funds have had net inflows just once in the past five years, in 2010. Investors have pulled a net $305 billion from such funds since the end of 2007.

Taxable bond funds, on the other hand, last had annual net outflows in 2000 and since the end of 2007 have taken in a total of $834 billion, Tjornehoj said.

On the corporate side, a number of initial public offerings have been pulled or delayed in the wake of Facebook's fumbled IPO. While Facebook's $16 billion offering made the second quarter the strongest period on record for dollars raised, the number of deals fell by 50 percent to 11 in the quarter versus the same period last year, according to data from the National Venture Capital Association and Thomson Reuters.

Major technical problems on the Nasdaq exchange that messed up the first day of Facebook trading were not the only issue to sting investor confidence. Analysts at Morgan Stanley and other underwriters cut their earnings and revenue forecasts on Facebook only days before the IPO -- but they only told select clients, inflaming concerns that retail investors are saddled with a big handicap.

"The investor needs to be confident that he has a fair shot, that the deck is not stacked against him, or he will pull his capital out, unless something happens to convince him he should stay in," said Jeddeloh, of the TIS Group.

The Libor scandal may be the most insidious.

More than a dozen banks are under investigation by authorities in Europe, Japan and the United States over suspected rigging of Libor, which is used to set many lending and borrowing rates on hundreds of trillions of contracts globally, influencing rates on everything from home mortgages to student loans and credit cards. British bank Barclays has agreed to pay fines of $453 million and its top three executives have quit after the release of emails showing traders at the bank brazenly seeking to manipulate Libor rates.

Many other major banks are expected to reach settlements with the authorities or face prosecution, and some individuals could also face criminal charges. Litigation from those who claim they suffered losses because of the manipulation is expected to embroil the banks in legal hell for some years and could potentially cost them trillions of dollars.

In the current scandal-ridden climate, Wall Street should not be surprised by how weak sentiment and expectations are, said Doug Kass, president of hedge fund Seabreeze Partners Management Inc. There are many reasons, he recently said, that "underscore to many investors that the system is rigged" including Libor, Madoff, Stanford, MF Global and PFGBest.

"Why should an investor be optimistic and feel safe under these circumstances?" he asked. 

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