By Tim Husson, PhD and Olivia Wang, PhD
According to the Wall Street Journal today, several banks may soon face charges related to the disclosure of risks related to their sales of mortgage-backed-securities in 2006. The SEC is reportedly concerned about whether these banks "misled investors about the underlying pool of assets."
We have several posts lately and a research paper on similar disclosure issues for both collateralized loan obligations and mortgage-backed-securities, in which we describe how the warehousing of assets before the closing date of a deal could allow banks to hide losses on these assets from investors. Our research into these issues is ongoing and we will continue to follow the regulatory actions taken in regard to these complex securities.
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Wednesday, February 29, 2012
Tuesday, February 28, 2012
More Examples of CDO Warehousing and Potential Fraud
By Tim Husson, PhD and Olivia Wang, PhD
Last month we had a blog post about Banc of America Securities selling investors CLOs which had already lost value before the CLO closing date. It seems that in July 2007 Banc of America transferred at least $35 million of previous losses to unsuspecting investors in two of its CLO offerings – LCM VII and Bryn Mawr II. In October 2008 when these two CLOs were liquidated investors lost nearly $150 million. But it is unlikely that these were the only structured deals that hid the true value of their holdings from investors.
Last April the SEC settled claims against Wachovia for allegedly violating the antifraud provisions of the Securities Act by selling the equity tranche of the Grand Avenue CDO II and misrepresenting the collateral acquisition process of the Longshore CDO Funding 2007-3. Both of the CDOs involved are residential mortgage-backed securities (RMBS), a complex financial product that is similar to CLOs.
According to the SEC order, the Grand Avenue CDO II was issued in October 2006 but Wachovia Capital Markets was not able to sell the equity tranche at the initial offering, which was then retained in Wachovia’s inventory and marked at a value of 52.7% of par. However, a few months later, Wachovia sold $5.5 million of the equity tranche to the Zuni Indian Tribe and an individual investor at 90% and 95% of par. SLCG's Craig McCann has worked as an expert consultant for the Zuni Indian Tribe against Wachovia.
In addition, Wachovia allegedly transferred 40 RMBS securities (a total notional value of $250 million) it had obtained for another CDO into the warehouse for Longshore 3 at acquisition cost. Similar to the portfolio of loans warehoused in the LCM VII and Bryn Mawr II deals, these RMBS had already lost about $4.6 million in value between the acquisition and the transfer. Although required by the ABS CDO Investment Management Committee (the “IMC”) to make certain disclosures to investors about the issue mentioned above, Wachovia allegedly failed to do so. According to the SEC Wachovia falsely claimed it acquired the collateral assets for Longshore 3 “on an arm’s-length basis”.
While Wachovia (now Wells Fargo) admitted no wrongdoing, the facts alleged by the SEC demonstrate that the problem of asset warehousing is not limited to Banc of America Securities or even CLOs, but could be pervasive in many forms of structured credit deals.
Last month we had a blog post about Banc of America Securities selling investors CLOs which had already lost value before the CLO closing date. It seems that in July 2007 Banc of America transferred at least $35 million of previous losses to unsuspecting investors in two of its CLO offerings – LCM VII and Bryn Mawr II. In October 2008 when these two CLOs were liquidated investors lost nearly $150 million. But it is unlikely that these were the only structured deals that hid the true value of their holdings from investors.
Last April the SEC settled claims against Wachovia for allegedly violating the antifraud provisions of the Securities Act by selling the equity tranche of the Grand Avenue CDO II and misrepresenting the collateral acquisition process of the Longshore CDO Funding 2007-3. Both of the CDOs involved are residential mortgage-backed securities (RMBS), a complex financial product that is similar to CLOs.
According to the SEC order, the Grand Avenue CDO II was issued in October 2006 but Wachovia Capital Markets was not able to sell the equity tranche at the initial offering, which was then retained in Wachovia’s inventory and marked at a value of 52.7% of par. However, a few months later, Wachovia sold $5.5 million of the equity tranche to the Zuni Indian Tribe and an individual investor at 90% and 95% of par. SLCG's Craig McCann has worked as an expert consultant for the Zuni Indian Tribe against Wachovia.
In addition, Wachovia allegedly transferred 40 RMBS securities (a total notional value of $250 million) it had obtained for another CDO into the warehouse for Longshore 3 at acquisition cost. Similar to the portfolio of loans warehoused in the LCM VII and Bryn Mawr II deals, these RMBS had already lost about $4.6 million in value between the acquisition and the transfer. Although required by the ABS CDO Investment Management Committee (the “IMC”) to make certain disclosures to investors about the issue mentioned above, Wachovia allegedly failed to do so. According to the SEC Wachovia falsely claimed it acquired the collateral assets for Longshore 3 “on an arm’s-length basis”.
While Wachovia (now Wells Fargo) admitted no wrongdoing, the facts alleged by the SEC demonstrate that the problem of asset warehousing is not limited to Banc of America Securities or even CLOs, but could be pervasive in many forms of structured credit deals.
Monday, February 27, 2012
Mutual Fund Expense Analyzer: A Tool for Calculating Mutual Fund Fees and Expenses
By Geng Deng, PhD, FRM, Tim Husson, PhD and Olivia Wang, PhD
Every mutual fund investor should know how important fees and expenses are in determining the net return of his investment. Compared with other factors affecting a mutual fund’s or an Exchange Traded Fund (ETF)’s return, such as market returns, fees and expenses are more stable over time and it is therefore easier to predict their effect on a fund’s future performance. However, comparing fees and expenses across funds can be tedious and confusing, as different funds can use different fee structures.
Luckily, FINRA provides a free online tool which allows investors to compare the fees and expenses charged by over 18,000 mutual funds, ETFs and Exchange Traded Notes (ETNs). For example, we could choose three of the largest mutual funds, PIMCO Total Return Fund Institutional Class with ticker PTTRX, Fidelity Cash Reserves Fund with ticker FDRXX, and SPDR S&P 500 ETF with ticker SPY to compare their cost structures. The output is shown in Table 1:
Several inputs are required when generating this table. Here, we assume the initial investment amount is $10,000 and the investment horizon is ten years for all three funds. Also, we assume the annual return is 3% for all three funds. This assumption of uniform returns across the funds is not realistic, but it serves the purpose of making the cost structure more transparent.
This table makes clear the advantage of ETFs in terms of fees and expenses over conventional mutual funds: the total fees and sales changes for PIMCO total return fund is about five time of that of the SPDR S&P 500 ETF. Indeed, another piece of information provided by this tool (not shown in the table) is the annual operating expenses for each fund: while the expense is 0.09% for SPDR S&P 500 ETF, it is 0.46% for PIMCO Total Return Fund Institutional Class. This tool also outputs a wide variety of other data, including Morningstar ratings, investment objectives, and average annual returns.
We are glad that FINRA is making an effort to help investors make well-informed decisions. Although fee structures are not the only factor an investor should consider when choosing a mutual fund or ETF, this tool at least provides an objective comparison of known costs.
Every mutual fund investor should know how important fees and expenses are in determining the net return of his investment. Compared with other factors affecting a mutual fund’s or an Exchange Traded Fund (ETF)’s return, such as market returns, fees and expenses are more stable over time and it is therefore easier to predict their effect on a fund’s future performance. However, comparing fees and expenses across funds can be tedious and confusing, as different funds can use different fee structures.
Luckily, FINRA provides a free online tool which allows investors to compare the fees and expenses charged by over 18,000 mutual funds, ETFs and Exchange Traded Notes (ETNs). For example, we could choose three of the largest mutual funds, PIMCO Total Return Fund Institutional Class with ticker PTTRX, Fidelity Cash Reserves Fund with ticker FDRXX, and SPDR S&P 500 ETF with ticker SPY to compare their cost structures. The output is shown in Table 1:
Table 1
PIMCO Total Return Fund Institutional Class
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Fidelity Cash Reserves Fund
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SPDR S&P 500 ETF
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Data as of
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Data as of
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Data as of
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2/14/2012
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2/22/2012
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n/a
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Ticker Symbol
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PTTRX
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FDRXX
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SPY
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Investment Amount
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$10,000.00
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$10,000.00
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$10,000.00
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Estimated Return
You Selected
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3.00%
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3.00%
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3.00%
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Holding Period
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10
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10
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10
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Fund Value After 10
Year(s)
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$12,834.99
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$12,951.02
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$13,318.76
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Profit/Loss
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$2,834.99
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$2,951.02
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$3,318.76
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Total Fees &
Sales Charges
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$522.50
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$422.25
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$104.22
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Total Fees
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$522.50
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$422.25
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$104.22
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Total Sales Charges
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$0.00
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$0.00
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$0.00
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Several inputs are required when generating this table. Here, we assume the initial investment amount is $10,000 and the investment horizon is ten years for all three funds. Also, we assume the annual return is 3% for all three funds. This assumption of uniform returns across the funds is not realistic, but it serves the purpose of making the cost structure more transparent.
This table makes clear the advantage of ETFs in terms of fees and expenses over conventional mutual funds: the total fees and sales changes for PIMCO total return fund is about five time of that of the SPDR S&P 500 ETF. Indeed, another piece of information provided by this tool (not shown in the table) is the annual operating expenses for each fund: while the expense is 0.09% for SPDR S&P 500 ETF, it is 0.46% for PIMCO Total Return Fund Institutional Class. This tool also outputs a wide variety of other data, including Morningstar ratings, investment objectives, and average annual returns.
We are glad that FINRA is making an effort to help investors make well-informed decisions. Although fee structures are not the only factor an investor should consider when choosing a mutual fund or ETF, this tool at least provides an objective comparison of known costs.
Friday, February 24, 2012
WSJ: Private-Equity Fund in Valuation Inquiry
By Tim Dulaney, PhD and Craig McCann, PhD, CFA
There is an article in the Wall Street Journal today concerning the alleged exaggeration of an asset's value in a private-equity fund. From the article:
There is an article in the Wall Street Journal today concerning the alleged exaggeration of an asset's value in a private-equity fund. From the article:
The potential exaggeration in the [Oppenheimer Global Resource Private Equity Fund LP] grew to more than $4 million, according to documents shared with Oppenheimer investors. The bulk of this markup came as the fund was reaching out to potential investors in the fall of 2009, and helped push the fund's reported internal rate of return to 38%, after fees, from a loss of 6.3%.
Following the alleged exaggeration, the fund raised more than $55 million from individuals, an academic institution and municipalities. Such decision makers (perhaps non-profits and municipal issuers in particular) are vulnerable targets for abusive sales resulting from over-exaggerated asset valuation.
Hedge funds often hold illiquid or even obscure assets. For example, the asset under scrutiny in this case was an investment in a fund (Cartesian Investors A LP) with shares in a single asset: "a closed-end fund set up by the Romanian government to benefit citizens whose property was expropriated during Communist rule." The lack of liquidity of the underlying investments allows the hedge funds to report inflated asset values and control the reported "appreciation".
This ability to value assets with great discretion generates smoothed returns superficially reflecting characteristics of low-risk investments (sometimes masking extraordinarily high risk investments). Both FINRA and the SEC have written about the risks of hedge fund investing. Since many hedge funds do not register with the SEC, investors are not protected by the relatively high exposure of registered securities. As such, it is often difficult to independently verify information reported by hedge funds.
We'll be keeping an eye on this story as it develops.
This ability to value assets with great discretion generates smoothed returns superficially reflecting characteristics of low-risk investments (sometimes masking extraordinarily high risk investments). Both FINRA and the SEC have written about the risks of hedge fund investing. Since many hedge funds do not register with the SEC, investors are not protected by the relatively high exposure of registered securities. As such, it is often difficult to independently verify information reported by hedge funds.
We'll be keeping an eye on this story as it develops.
SEC Litigation Releases: Week in Review
by Tim Dulaney, PhD
Federal Court Enters Order Imposing $2.5 Million Civil Penalty Against Investment Adviser Robert Glenn Bard and Vision Specialist Group, LLC., February 23, 2012 (Litigation Release No. 22267)
In July 2009 (Litigation Release No. 21160) the SEC stopped a fraud allegedly being perpetrated by Robert Glen Bard and his firm (Vision Specialist Group, LLC.). According to the SEC, Bard targeted residents of small rural communities promising high yields on relatively safe investments (such as CDs or Bonds) relying upon his and his family's reputation. Bard allegedly then turned around and invested the funds in risky assets (such as penny stocks) realizing losses and, at the same time, produced false and misleading account statements for his clients. Earlier this month, the US District Court for the Middle District of Pennsylvania imposed a $2.5 million civil penalty for Bard's and his firm's actions in this matter.
Jeremy Blackburn and Anthony Banas Sentenced for Defrauding Investors, February 22, 2012 (Litigation Release No. 22266)
Earlier this month, Jeremy Blackburn (formerly Canopy Financial, Inc.'s president and COO) and Anthony Banas (formerly Canopy Financial, Inc.'s CTO) were sentenced to 180 months and 160 months, respectively, for their involvement in the investor fraud facilitated through their now bankrupt healthcare transaction-software company. According to the release, "[b]oth men pleaded guilty in late 2010 to one count of wire fraud, admitting they engaged in a fraud scheme that cheated investors of approximately $75 million and also misappropriated more than $18 million from customer accounts intended for health care savings and expenses."
SEC Seeks Court Approval for Plan of Distribution in BISYS Financial Reporting Case, February 22, 2012 (Litigation Release No. 22265)
In May 2007, the SEC filed a civil injunctive action (link opens PDF) alleging that The BISYS Group, Inc. violated "the financial reporting, books-and-records, and internal control provisions of the Securities Exchange Act of 1934." As a result of the complaint, the company paid approximately $25 million. These funds, in combination with those from a related complaint, are now to be distributed to shareholders who held BISYS stock between October 23, 2000 and April 22, 2003 (and suffered a loss on their investment) pending court approval of the distribution plan.
SEC Charges Chairman and Ex-CEO of Puda Coal With Fraud, February 22, 2012 (Litigation Release No. 22264)
On Wednesday, the SEC filed a civil injunctive action (link opens PDF) in the US District Court for the Southern District of New York alleging Ming Zhao (Chairman of Puda Coal, Inc.) and Liping Zhu (former CEO of Puda Coal, Inc.) "with securities fraud for the undisclosed theft of the primary asset of the U.S. public company they controlled." Zhao allegedly transferred the 90% indirect ownership stake in Shanxi Puda Coal Group Co., Ltd. to himself just weeks before the coal company was to publicly announce a "highly lucrative mandate from the provincial government". A 49% stake in Shanxi Coal was transferred to a trust set up by CITIC Trust Co., Ltd. These transfers were neither approved by the board of Puda Coal, Inc. or reported in SEC filings. Puda Coal, Inc. allegedly "also conducted two public offerings in 2010 in the U.S. without disclosing that it no longer had any ownership stake in [Shanxi Puda Coal Group Co., Ltd.], Puda’s sole source of revenue."
SEC Charges Individual and Three of his Companies with Running Illegal Ponzi Schemes, February 21, 2012 (Litigation Release No. 22263)Federal Court Enters Order Imposing $2.5 Million Civil Penalty Against Investment Adviser Robert Glenn Bard and Vision Specialist Group, LLC., February 23, 2012 (Litigation Release No. 22267)
In July 2009 (Litigation Release No. 21160) the SEC stopped a fraud allegedly being perpetrated by Robert Glen Bard and his firm (Vision Specialist Group, LLC.). According to the SEC, Bard targeted residents of small rural communities promising high yields on relatively safe investments (such as CDs or Bonds) relying upon his and his family's reputation. Bard allegedly then turned around and invested the funds in risky assets (such as penny stocks) realizing losses and, at the same time, produced false and misleading account statements for his clients. Earlier this month, the US District Court for the Middle District of Pennsylvania imposed a $2.5 million civil penalty for Bard's and his firm's actions in this matter.
Jeremy Blackburn and Anthony Banas Sentenced for Defrauding Investors, February 22, 2012 (Litigation Release No. 22266)
Earlier this month, Jeremy Blackburn (formerly Canopy Financial, Inc.'s president and COO) and Anthony Banas (formerly Canopy Financial, Inc.'s CTO) were sentenced to 180 months and 160 months, respectively, for their involvement in the investor fraud facilitated through their now bankrupt healthcare transaction-software company. According to the release, "[b]oth men pleaded guilty in late 2010 to one count of wire fraud, admitting they engaged in a fraud scheme that cheated investors of approximately $75 million and also misappropriated more than $18 million from customer accounts intended for health care savings and expenses."
SEC Seeks Court Approval for Plan of Distribution in BISYS Financial Reporting Case, February 22, 2012 (Litigation Release No. 22265)
In May 2007, the SEC filed a civil injunctive action (link opens PDF) alleging that The BISYS Group, Inc. violated "the financial reporting, books-and-records, and internal control provisions of the Securities Exchange Act of 1934." As a result of the complaint, the company paid approximately $25 million. These funds, in combination with those from a related complaint, are now to be distributed to shareholders who held BISYS stock between October 23, 2000 and April 22, 2003 (and suffered a loss on their investment) pending court approval of the distribution plan.
SEC Charges Chairman and Ex-CEO of Puda Coal With Fraud, February 22, 2012 (Litigation Release No. 22264)
On Wednesday, the SEC filed a civil injunctive action (link opens PDF) in the US District Court for the Southern District of New York alleging Ming Zhao (Chairman of Puda Coal, Inc.) and Liping Zhu (former CEO of Puda Coal, Inc.) "with securities fraud for the undisclosed theft of the primary asset of the U.S. public company they controlled." Zhao allegedly transferred the 90% indirect ownership stake in Shanxi Puda Coal Group Co., Ltd. to himself just weeks before the coal company was to publicly announce a "highly lucrative mandate from the provincial government". A 49% stake in Shanxi Coal was transferred to a trust set up by CITIC Trust Co., Ltd. These transfers were neither approved by the board of Puda Coal, Inc. or reported in SEC filings. Puda Coal, Inc. allegedly "also conducted two public offerings in 2010 in the U.S. without disclosing that it no longer had any ownership stake in [Shanxi Puda Coal Group Co., Ltd.], Puda’s sole source of revenue."
Earlier this week, the SEC filed a complaint (link opens PDF) alleging Steven L. Hamilton, along with three of his companies (Verde Retirement LLC, Verde FX Nevada, LLC, Covenant Capital Partners), had defrauded 23 clients out of over $1.5 million through a series of Ponzi schemes. Hamilton allegedly collected investor funds under the pretense of investing in real estate loans secured by deeds of trust, CDs or construction projects. The SEC alleges that Hamilton instead used the funds "to pay his personal living expenses and return capital to investors."
Court Finds Pentagon Capital Management PLC and Lewis Chester Liable for Securities Fraud, February 17, 2012 (Litigation Release No. 22262)
In April 2008 (Litigation Release No. 20516), the SEC filed a complaint alleging that Pentagon Capital Management PLC and its CEO Lewis Chester "orchestrated a scheme to defraud mutual funds in the United States and their shareholders through late trading and deceptive market timing." The SEC alleges that Pentagon Capital management would accept the current day's mutual fund price but actually evaluate the transaction after the market has closed (when the mutual funds had calculated their net asset values) allegedly earning over $60 million in illicit profits. The district court issued an opinion (link opens PDF) in the matter last week stating that the defendants "intentionally, and egregiously violated the federal securities laws through a scheme of late trading". Judge Sweet, who presided over the case, found Pentagon Capital Management liable for disgorgement of over $38 million and imposed civil penalties for the same amount.
SEC Charges Oregon-Based Expert Consulting Firm and Owner with Insider Trading in Technology Sector, February 17, 2012 (Litigation Release No. 22261)
The SEC rcently filed a civil injunctive action (link opens PDF) in the US District Court of the Southern District of New York last week alleging John Kinnucan and his expert consulting firm Broadband Research Corporation had facilitated insider trading by disclosing material non-public information. During 2009 and 2010, hedge funds and investment advisers would hire Kinnucan for supposedly legitimate research concerning technology companies. Kinnucan would then allegedly disclose material non-public information obtained from well-placed sources within publicly-traded technology companies to his firm's clients. During this period, the SEC alleges that the "insider trading resulted in profits or avoided losses of nearly $1.6 million" and that Kinnucan "generated hundreds of thousands of dollars in annual revenues for Broadband."
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