What American Investors Need to Know About Russia's Financial Crisis

'Tis the season to be jolly, but Michael Douglass and John Maxfield aren't afraid to examine the darker side of the news, including Russia's chaotic currency, Elizabeth Warren's warnings, and allegations of alarming accounting practices at mortgage REITs.

Tune in to this financial edition of Industry Focus to learn more about this troubled time in Russia's economic history, whether Maxfield agrees with Warren's concerns, and what it means -- to executives and to shareholders -- when a REIT externalizes its management.

A full transcript follows the video.

Michael Douglass: Turmoil in the ruble, fraud at a REIT, and Elizabeth Warren takes aim at Citigroup (C -0.32%). This is Industry Focus.

Hi Fools, Financial Analyst Michael Douglass here with our senior banking specialist John Maxfield, and we've got a packed show today. John, how's Portland?

John Maxfield: It's great. It's great, and it's particularly great that we have this technology that I can see you, all across the country, in real time. It's wonderful, Michael. I will say this; there is so much joy and cheer coursing through society right now, it must be driving you nuts!

Douglass: Yes, a little bit! Fortunately, we can turn to the stock market and find really quite the opposite going on.

It's been kind of a crazy couple weeks in the market. The Russian rate jump; huge turmoil with the ruble, of course connected to the issues with oil prices, oil prices falling, the ruble crashing against the dollar. Let's talk through that. What's the background there?

Maxfield: The background is this. The United States put some economic sanctions onto Russia, following the Ukraine ordeal. Then OPEC came in, and they are pushing oil prices down. I think oil prices have fallen something like 50% over the last few months.

The problem with this for a country like Russia, that exports a lot of oil and natural gas, is that by driving down that price, it reduces the demand for their currency because not as much "stuff," so to speak, is being purchased from Russia.

By reducing the demand for their currency, it tanks the value. Right now, over the past three months or over the past two months, the value of the ruble has fallen by 42%, which is extraordinary for a country the size of Russia.

Douglass: Yes, it's definitely a big deal. Imagine if that happened in the United States. Heck, let's face it a 2% currency fluctuation in the United States is a big deal. Russia's response has been to hike interest rates.

Maxfield: That's exactly right.

Douglass: How is that panning out?

Maxfield: It remains to be seen. This is an unfolding story. Last week, they hiked their benchmark interest rate from something like 10.5% all the way up to 17%. As a comparison, in the United States when the Federal Reserve moves interest rates by a half a percent, a quarter percent, that is a market-moving decision by the Federal Reserve.

When you consider that Russia's central bank increased interest rates by 7%, up to 17% -- and these are short-term benchmark rates -- it is incredible.

This is something we were talking about earlier. Now we're starting to see the reverberations through the Russian economy, and just this morning the Russian regulators went in and seized a bank because all this turmoil in the economy is threatening the solvency of their banks.

It remains to be seen how that will work its way through the rest of the economy, but it is definitely a story that anybody interested in history or economics, or anything like that, should definitely watch, just to see how it unfolds.

Douglass: We're also, here, interested in the world market because certainly massive trouble at what is a pretty darn big market is definitely of concern to all of us across the pond. Definitely something we'll want to watch very closely.

Any final thoughts there, John?

Maxfield: No. This is just a fascinating thing to watch. If nothing else, it shows that economic sanctions ... there's a lot of angst when a U.S. president will come in and instead of using more coercive measures, they'll just revert to economic sanctions.

But we saw this same thing work really effectively with Iran at the end of 2011 when their currency shot way down, just like Russia's has, and it's really pushed them to the negotiating table.

Probably, even in addition to the market stuff -- it's hard to say how this is going to play out in common stocks in the United States in particular -- but even beyond that, this shows us just how effective these type of measures can be.

Douglass: Yes, absolutely; both public policy and the money, and then of course as you mentioned, history and economic set of lessons to be learned here. Very interesting for us. This is definitely something we'll want to watch, moving forward.

Let's turn to our second story. The ex American Realty Capital Properties chair has been accused of ordering accounting changes, according to our good friends at the Wall Street Journal -- so basically, fraud in a mortgage REIT, which is something that I think has been depressingly familiar.

Maxfield: Yes, we've seen this on a number of occasions over the last few years. What's going on at American Realty Capital partners is, there's a non-GAAP measure of cash flow that and executives tell shareholders, "Look, this is a more accurate reflection of our fundamental performance than net income," so they're telling all their shareholders to look at this number.

Well, it turns out that the executive at the very top -- and this is all still alleged, but it seems to be relatively convincing -- that both the chairman and this current CEO of American Realty partners was telling the accounting department to artificially inflate this proxy for income that shareholders should be following.

There was a lawsuit filed last week that's really starting to flesh out the facts here. What's unfortunate is that when you look at what's going on not only at American Realty, but what's going on at, say Annaly Capital Management (NLY -0.32%) and Chimera Investment Corporation (CIM -0.48%), which is a publicly traded portfolio company that's also a REIT of Annaly Capital Management.

Then in the BDC realm -- that's Business Development Company realm -- which are similarly structured investment funds that are publicly traded, that invest in the debt of companies that are involved in leveraged finance transactions, we've seen similar things going on at Prospect Capital Corporation (PSEC 0.46%).

Let's just look at each one of these. At Annaly Capital Management they've taken their management and they've externalized it. By doing that, they've effectively sapped all the intrinsic value out of this corporate entity, other than the assets in the portfolio itself.

At Chimera, they too have an accounting irregularity that overstated its income since inception between 2007 and 2011 by a factor of three, so they actually earned $367 million, whereas before they were claiming to earn over $1 billion -- so a very large difference there.

Then in Prospect's case, they recently went through a transaction where they sold one of their portfolio companies, and they did it in a way that artificially hiked the fees that the external manager will receive, which means that the managers of Prospect will earn more money themselves, at the expense of shareholders.

Unfortunately, it's a really disappointing trend that we're seeing among these high-yielding stocks, and particularly because a lot of the investors in these companies, we can presume, are income-seeking investors -- which often are retirees.

Douglass: Yes. Let's unpack this piece-by-piece a little bit.

First off, external management; basically this idea that your CEO is actually paid by this other corporate entity and you just pay, let's say, a flat fee. Usually the numbers I see are like 1.5% of assets under management, something like that.

That really doesn't seem to align with shareholder needs, right? Particularly because often there's not even an incentive bonus paid based on performance. They just are paid based on assets under management.

Maxfield: Yes, to a certain extent that's true. When you externalize your management in these types of companies, the biggest benefit to the management itself is that they no longer have to report how their executives themselves are being compensated -- because that's a big part of the SEC's regulations that were put into place back in the Great Depression.

Shareholders, they are the owners of these companies. They have the right to know both how much and in which way the executives of the companies that the shareholders own are being compensated. By structuring it in this external management way, they just don't see that.

Douglass: No, that is definitely a very interesting and disconcerting problem.

Maxfield: Let me just bring up one more point. Another problem that we see with these companies ... the question is, why are these companies particularly prone to this type of behavior?

Douglass: I was about to ask this. You took the words right out of my mouth, John!

Maxfield: Right. One of the reasons is that the legal structure allows them to reduce transparency, but on top of that some of these companies used to not be externally managed, like Annaly, but then they switched to internal management so we actually have a window into how they compensated themselves before.

At Annaly in particular, one of the things they did is their incentive bonus structure for their executives would compensate the executives for growth in book value. Growth in book value at a REIT, the only way that can be accomplished is by issuing more shares of common stock.

The reason for this is because REITs, in order to get preferential tax treatment -- which is the biggest benefit to running a REIT -- the REIT itself has to distribute at least 90% of taxable income to shareholders.

Well, if you're distributing basically all of your income to shareholders there's only one way to grow book value, and that is to just issue more shares of common stock. When you put all this together, it looks more like a multi-level marketing company -- and I don't mean that in a positive way -- than it does a traditional investment trust.

Douglass: Yes, I think that's a very good point. One of the reasons that -- me, personally -- I've shied away from BDCs and mREITs is just because it does seem that there's this issue with alignment and these issues with transparency.

Do you see any attractive plays in the space, or because of these issues are they just generally, for you, stay-aways?

Maxfield: Look, let me say first off that I am extremely sympathetic to the shareholders of these companies. These are people who are going after income. These are probably people who are in retirement and don't have a lot of extra space to play with. They need that income to survive on.

The problem, in my opinion, is that if you believe that the integrity of executives is important, then this is a sector that, as a general rule, you should probably avoid. If you're looking for a decent dividend stock, you should probably go more in the blue chip direction.

Douglass: I think that makes good sense.

Speaking of which, let's go ahead and turn to our third story; Elizabeth Warren definitely taking aim at Citigroup. Her argument has been that Citigroup has way too much influence, and I would say generally, that big banks have way too much influence on Capitol Hill. But that doesn't seem like quite your contention, John.

Maxfield: Right. Elizabeth Warren is saying, "Look. If you go through all these different departments in the Executive Branch, there are a shocking number of Citigroup -- either alum, or people who then subsequently have gone on to work at Citigroup." She doesn't like this because it shows the over-influence of Wall Street.

My contention is that the problem isn't that a huge bank like Citigroup, which has $2 trillion in assets on its balance sheet, the problem isn't that they are putting people into positions in Washington. Who else who has the expertise to make financial decisions for the country at large, other than these financiers who have all this experience, right?

The problem, instead, is that they're getting them from Citigroup in particular and -- this is something I've talked about on numerous occasions, as you know, Michael -- Citigroup is probably one of the worst-run banks in the country over the past 100 years.

Let me just go through a short list to give you an idea. In the early 1920s there were sugar loans to Cuba that threatened to wipe out the entire capital of Citigroup.

Later in that same decade, it had a securities affiliate that was repackaging failed bank loans to emerging market countries in Latin America. They were repackaging into bonds and then selling those bonds to individual investors like you and me. This is one of the reasons why Glass Steagall came about at the time.

In the early 1930s there was a guy by the name of Ivar Kreuger who was basically the equivalent of Bernie Madoff in the 1930s. They were financing his Ponzi scheme operation.

Half a century later, it lent billions of dollars to the same Latin American countries that defaulted and cost all those mom & pop investors all that money during the Great Depression. It was doing that again; it almost went under again in the 1980s.

In the 1990s, it fueled the Internet bubble because it had analysts going out and artificially pumping up these stocks of their clients. After the turn of the century, it was fined nearly $5 billion for aiding and abetting the frauds at Enron and WorldCom, and of course just recently we had all this debacle that Citigroup would have gone under, but for the intervention of the federal government during the financial crisis.

The question isn't so much why do financiers at these large corporations have influence in Washington. The question is why in the world would we want the people at Citigroup in these positions, given their record?

Douglass: Yes. Certainly given, as you've noted many times, the stock's performance, the business' performance, which we like to think is pretty closely correlated to the price, and as you know the laundry list of enormous problems; that seems to be, I think, a very appropriate question to be asking.

Certainly there are some much more attractive banks for regulators to perhaps be trying to poach people from.

That's a good note for us to end on. John, thanks as always for your contributions. Folks who are listening and watching, stay tuned to Fool.com for all of your banking, financial, Russian ruble, and other investing needs, and Fool on!