SEC Charges Atlanta-Area Registered Representative and Registered Investment Adviser Representative with Securities Fraud, May 23, 2013, (Litigation Release No. 22706)
According to the complaint (PDF), since at least 2008 Blake Richards, "a registered representative of a broker dealer, misappropriated at least $2 million from at least seven investors." Allegedly, the "majority of the misappropriated funds constituted retirement savings and/or life insurance proceeds from deceased spouses." An order was issued that "temporarily restrained Richards from further securities laws violations, froze Richards’s assets, prevented the destruction of documents, and expedited discovery." The SEC has charged Richards with violating various provisions of the Securities Act and Exchange Act and seeks permanent injunction, disgorgement, prejudgment interest, and civil penalties.
SEC Charges Director's Brother, and His Friend and His Relative, with Insider Trading in Shares of a Medical Professional Liability Insurer, May 22, 2013, (Litigation Release No. 22705)
According to the complaint (PDF), John A. Stilwell along with his friend, Dr. Michael C. Moore, and sister-in-law, Jillian M. Murphy, traded on insider information that Stilwell gained from his brother, an American Physicians Capital, Inc. director. The insider information involved ACAP's possible acquisition by The Doctors Company. Moore and Murphy allegedly each tipped another person. In total, the four tippees made almost $62,000 in illicit profits. The defendants agreed to settle charges by agreeing to a final judgment that permanently enjoins them future violations of the Exchange Act, as well as orders them to pay disgorgement, prejudgment interest, and financial penalties.
Securities and Exchange Commission v. Ren Hu, May 20, 2013, (Litigation Release No. 22704)
A final judgment was entered against China Yingxia's former chief financial officer, Ren Hu. Hu allegedly made "fraudulent representations in Sarbanes-Oxley certifications" and failed to "implement internal controls, aided and abetted China Yingxia's failure to do so, and made materially misleading statements to auditors concerning such controls and potential fraud by the CEO." The final judgment imposes a permanent injunction against Hu from future violations of the Exchange Act and also "imposes a 3-year officer and director bar against Hu but does not include any civil monetary penalty based on Hu's financial condition."
SEC Charges Chicago-Area Father and Son Conducting Cherry-Picking Scheme At Investment Firm, May 17, 2013, (Litigation Release No. 22703)
According to the complaint (PDF), father-and-son duo, Charles J. Dushek and Charles S. Dushek, along with their investment advisory firm, Capital Management Associates, Inc., (CMA) defrauded "CMA clients in a cherry picking scheme that garnered the Dusheks nearly $2 million in illicit profits." The scheme went on for 17 quarters and caused at least one of "Dushek Sr.’s personal accounts [to] increase...in value by almost 25,000 percent." The SEC has charged the defendants with violating various provisions of the securities laws and seeks permanent injunctions, civil penalties, disgorgement, and prejudgment interest. Additionally, Margaret Dushek was named as a relief defendant.
SEC Charges Resident in the Atlanta Area and His Firm with Fraud in Connection with Prime Bank Scheme, May 17, 2013, (Litigation Release No. 22702)
According to the complaint (PDF), Robert Fowler and his company, US Capital Funding Series II Trust 1, defrauded " investors in a 'prime bank' investment scheme." Last August, the defendants allegedly "raised at least $350,000 from investors by falsely promising high profits for investing in standby letters of credit or bank guarantees that would purportedly grant the investors loans, the proceeds of which would be invested for a significant profit." These funds were misappropriated by Fowler and US Capital for "personal and business use." According to the SEC, Fowler preyed on "foreign-born small business owners with little or no experience in finance or investing." The SEC has charged Fowler and US Capital with violating the antifraud provisions of the securities laws and seeks "permanent injunctions, disgorgement of ill-gotten gains with prejudgment interest, and civil penalties."
Final Judgments Entered Against Connecticut-Based Investment Adviser and His Firm Charged with Fraud for Stealing Investor Funds, May 16, 2013, (Litigation Release No. 22701)
Final judgments were entered against Stephen B. Blankenship and his investment advisory firm, Deer Hill Financial Group, LLC for allegedly engaging in a scheme that defrauded investors of at least $600,000. The final judgment enjoins the defendants from future violations of the securities laws. Additionally, the SEC has "barred Blankenship from working in the securities industry."
Criminal charges arose from the same alleged misconduct and on December 5, 2012 Blankenship was sentenced "to forty-one months imprisonment plus three years of supervised release and ordered...to pay a fine of $7,500 and restitution in the amount of $607,516.81."
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Friday, May 24, 2013
Thursday, May 23, 2013
SEC Charges South Miami with Defrauding Investors
By Tim Dulaney, PhD and Tim Husson, PhD
Yesterday the Securities and Exchange Commission (SEC) charged the City of South Miami with defrauding investors over the tax-exempt status of some municipal offerings.
In 2002, the City of South Florida obtained access to tax-exempt financing through a pooled conduit municipal bond issued by the Florida Municipal Loan Council (FMLC) to fund the construction of a mixed-use retail and parking structure in the city's commercial district.* The 2002 FMLC bond offering can be found here (PDF). The funding was meant to cover the portion of the construction costs attributable to the parking structure in which the city would remain full control and receive all parking revenues. The city's access to tax-exempt financing depended critically on the limited role of the for-profit developer.
City officials became concerned with the municipality's ability to pay the debt service on the bonds and subsequently cancelled the project. Litigation with the developer followed and a settlement was reached in which the developer would lease the entire project (including the parking structure), jeopardizing the tax-exempt status of the bonds.
The City of South Miami sought additional funding from FMLC in 2006 to continue the project. However, in seeking this new funding the city omitted information concerning the new lease with the developer. FMLC issued pooled municipal bonds (PDF) in 2007 based on this omission and other material misrepresentations. City officials were reportedly aware of the failure to comply with IRS rules for tax-exempt financing and continued to issue certifications that the city was in compliance with the terms of the loan agreements.
It was not until July 2010 that the city formally recognized the adverse impact of the renegotiated lease with the developer on the tax-exempt status of the 2002 and 2007 bonds. The City of South Miami has settled with the IRS resulting in nearly $1.5 million in additional costs. From the viewpoint of the bondholders, the settlement effectively preserved the tax-exempt status of the bonds.
The City of South Miami has agreed to retain an independent third-party consultant to review financial disclosures and ensure compliance. The SEC order instituting cease-and-desist proceedings can be found here (PDF).
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* A pooled municipal bond offering is one in which an issuer uses the proceeds from a bond issuance to make loans to a set of municipalities. A conduit municipal bond is issued by a municipality that then loans the proceeds to a private entity. The private entity then repays the loan to the issuer and the issuer pays bond investors from the proceeds. Typically the municipality is not responsible for making up shortfalls on loan-repayments and as such these bonds are considered more risky than vanilla/non-conduit bonds. For more information about the basics of municipal bonds, see the Municipal Securities Rulemaking Board's website.
Yesterday the Securities and Exchange Commission (SEC) charged the City of South Miami with defrauding investors over the tax-exempt status of some municipal offerings.
In 2002, the City of South Florida obtained access to tax-exempt financing through a pooled conduit municipal bond issued by the Florida Municipal Loan Council (FMLC) to fund the construction of a mixed-use retail and parking structure in the city's commercial district.* The 2002 FMLC bond offering can be found here (PDF). The funding was meant to cover the portion of the construction costs attributable to the parking structure in which the city would remain full control and receive all parking revenues. The city's access to tax-exempt financing depended critically on the limited role of the for-profit developer.
City officials became concerned with the municipality's ability to pay the debt service on the bonds and subsequently cancelled the project. Litigation with the developer followed and a settlement was reached in which the developer would lease the entire project (including the parking structure), jeopardizing the tax-exempt status of the bonds.
The City of South Miami sought additional funding from FMLC in 2006 to continue the project. However, in seeking this new funding the city omitted information concerning the new lease with the developer. FMLC issued pooled municipal bonds (PDF) in 2007 based on this omission and other material misrepresentations. City officials were reportedly aware of the failure to comply with IRS rules for tax-exempt financing and continued to issue certifications that the city was in compliance with the terms of the loan agreements.
It was not until July 2010 that the city formally recognized the adverse impact of the renegotiated lease with the developer on the tax-exempt status of the 2002 and 2007 bonds. The City of South Miami has settled with the IRS resulting in nearly $1.5 million in additional costs. From the viewpoint of the bondholders, the settlement effectively preserved the tax-exempt status of the bonds.
The City of South Miami has agreed to retain an independent third-party consultant to review financial disclosures and ensure compliance. The SEC order instituting cease-and-desist proceedings can be found here (PDF).
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* A pooled municipal bond offering is one in which an issuer uses the proceeds from a bond issuance to make loans to a set of municipalities. A conduit municipal bond is issued by a municipality that then loans the proceeds to a private entity. The private entity then repays the loan to the issuer and the issuer pays bond investors from the proceeds. Typically the municipality is not responsible for making up shortfalls on loan-repayments and as such these bonds are considered more risky than vanilla/non-conduit bonds. For more information about the basics of municipal bonds, see the Municipal Securities Rulemaking Board's website.
Wednesday, May 22, 2013
Higher Expected Returns Only Come from Higher Risk: The Case of 130/30 Strategies
By Tim Dulaney, PhD and Tim Husson, PhD
JP Morgan recently released an "Investment Insight" that puts the spotlight on 130/30 strategies, which are used by several mutual funds and ETFs from a variety of issuers. A 130/30 strategy involves selling short 30% of the assets in a portfolio and using the proceeds to leverage the long securities to 130% of initial assets. The securities that are shorted are expected by the portfolio manager to depreciate during the holding period (overvalued) while the assets that are purchased are expected to appreciate in value during the holding period (undervalued). The report offered the following illustration of the strategy:
The JP Morgan report also notes that 130/30 strategies can increase returns while keeping the portfolio's beta--its relationship to the broader market--the same as a long-only portfolio. However, this does not mean that 130/30 strategies achieve riskless profits. Shorting securities involves a number of additional risks (including the potential for > 100% losses), even for large cap, highly liquid stocks. In addition, the 130/30 ratio is not fixed for all funds -- shorting is limited to 50% of assets by the leverage limits imposed by the Federal Reserve Board's Regulation T.
But perhaps the most important risk of 130/30 strategies is that they depend on the manager's ability to pick overvalued assets and undervalued assets. We've seen evidence, including recently updated evidence, that managers are not great at picking stocks within a given fund to beat a benchmark. Furthermore, there is evidence that managers often do no better than chance when outperforming their peers. In other words, if you're looking for a manager who will outperform half of their category peers, you are no better off looking at past performance than you are by flipping a coin.
Given this evidence, how much trust do you want to put into a fund that leverages their exposure to the manager's (or some proprietary algorithm's) stock picking ability? In 2009, a report on 130/30 funds found that their performance was severely lacking, and many 130/30 funds closed shortly after the financial collapse. That report, titled "130% Gimmick/30% Good Idea", included sweeping criticisms of the fundamentals of this strategy, especially that it is almost entirely dependent on hard-to-identify manager skill.
A fundamental concept of finance is the fact that higher expected returns only come at the cost of additional risk. Although JP Morgan states that there is no additional "market risk", there is additional risk and investors should not think that such strategies are a free lunch. As usual, investors should also be conscious of fees. Fees for these funds can be high and higher fees have a significant detrimental effect on realized investor returns.
JP Morgan recently released an "Investment Insight" that puts the spotlight on 130/30 strategies, which are used by several mutual funds and ETFs from a variety of issuers. A 130/30 strategy involves selling short 30% of the assets in a portfolio and using the proceeds to leverage the long securities to 130% of initial assets. The securities that are shorted are expected by the portfolio manager to depreciate during the holding period (overvalued) while the assets that are purchased are expected to appreciate in value during the holding period (undervalued). The report offered the following illustration of the strategy:
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| Source: JP Morgan |
But perhaps the most important risk of 130/30 strategies is that they depend on the manager's ability to pick overvalued assets and undervalued assets. We've seen evidence, including recently updated evidence, that managers are not great at picking stocks within a given fund to beat a benchmark. Furthermore, there is evidence that managers often do no better than chance when outperforming their peers. In other words, if you're looking for a manager who will outperform half of their category peers, you are no better off looking at past performance than you are by flipping a coin.
Given this evidence, how much trust do you want to put into a fund that leverages their exposure to the manager's (or some proprietary algorithm's) stock picking ability? In 2009, a report on 130/30 funds found that their performance was severely lacking, and many 130/30 funds closed shortly after the financial collapse. That report, titled "130% Gimmick/30% Good Idea", included sweeping criticisms of the fundamentals of this strategy, especially that it is almost entirely dependent on hard-to-identify manager skill.
A fundamental concept of finance is the fact that higher expected returns only come at the cost of additional risk. Although JP Morgan states that there is no additional "market risk", there is additional risk and investors should not think that such strategies are a free lunch. As usual, investors should also be conscious of fees. Fees for these funds can be high and higher fees have a significant detrimental effect on realized investor returns.
Tuesday, May 21, 2013
Fitch Rolls Out New Ratings Indenture Abstract
By Tim Dulaney, PhD and Tim Husson, PhD
It is looking more and more like collateralized debt obligations (CDOs) and other asset-backed securities-- the 'toxic' assets highlighted as some of the worst excesses of the financial crisis--are back. And while the agencies that rate asset-backed securities are still at the center of the debate over the validity of these investments, at least one of them is trying to improve its explanation of their labyrinthine terms and conditions.
Fitch has recently published the first example of their new "Indenture Abstracts," which provide a relatively digestible summary (at least to those familiar with these structures) in a form that is easier to navigate and more logically organized. The example* covers the Race Point VIII Collateralized Loan Obligation (CLO) which closed on February 20 of this year.
The March 13, 2013 prospectus for Race Point VIII CLO can be found on the Irish Stock Exchange's website. You'll notice that the prospectus is a staggering--though by no means unusual--three hundred pages of dense text that is cumbersome to parse. What Fitch has done with their new indenture abstracts is to provide a synopsis of some of the most important features of the deal in less than fifteen pages.
In addition, Fitch compares each deal with other similarly structured deals priced around the same time. On page 2 of the indenture abstract, Fitch compares Race Point VIII to it's predecessor Race Point VII CLO as well as two other deals of comparable size priced within a month of Race Point VIII. The comparison covers a broad range of important characteristics ranging from coupon rates of senior debt to the minimum weighted average spread on the portfolio constituents.
Perhaps our favorite feature is their abbreviation of principal and interest waterfall payments (page 7). These waterfalls determine if, when, and how much investors will receive for their investment in the CLO. This abbreviated structure allows investors to easily locate themselves in the waterfall and determine if that is where they would like to be in the priority of payments.
Obviously by dropping nearly three hundred pages from the prospectus, important information and disclosures are going to be lost. Any document of this type will not replace the prospectus, which still must be reviewed carefully by any potential investor. That said, good summaries of asset-backed securities are hard to find, and Fitch's abstracts are a significant improvement over previous descriptions. We applaud Fitch for their efforts to bring more transparency to this often murky market.
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* Access to the abstract is free, but you will need to create an account with Fitch.
It is looking more and more like collateralized debt obligations (CDOs) and other asset-backed securities-- the 'toxic' assets highlighted as some of the worst excesses of the financial crisis--are back. And while the agencies that rate asset-backed securities are still at the center of the debate over the validity of these investments, at least one of them is trying to improve its explanation of their labyrinthine terms and conditions.
Fitch has recently published the first example of their new "Indenture Abstracts," which provide a relatively digestible summary (at least to those familiar with these structures) in a form that is easier to navigate and more logically organized. The example* covers the Race Point VIII Collateralized Loan Obligation (CLO) which closed on February 20 of this year.
The March 13, 2013 prospectus for Race Point VIII CLO can be found on the Irish Stock Exchange's website. You'll notice that the prospectus is a staggering--though by no means unusual--three hundred pages of dense text that is cumbersome to parse. What Fitch has done with their new indenture abstracts is to provide a synopsis of some of the most important features of the deal in less than fifteen pages.
In addition, Fitch compares each deal with other similarly structured deals priced around the same time. On page 2 of the indenture abstract, Fitch compares Race Point VIII to it's predecessor Race Point VII CLO as well as two other deals of comparable size priced within a month of Race Point VIII. The comparison covers a broad range of important characteristics ranging from coupon rates of senior debt to the minimum weighted average spread on the portfolio constituents.
Perhaps our favorite feature is their abbreviation of principal and interest waterfall payments (page 7). These waterfalls determine if, when, and how much investors will receive for their investment in the CLO. This abbreviated structure allows investors to easily locate themselves in the waterfall and determine if that is where they would like to be in the priority of payments.
Obviously by dropping nearly three hundred pages from the prospectus, important information and disclosures are going to be lost. Any document of this type will not replace the prospectus, which still must be reviewed carefully by any potential investor. That said, good summaries of asset-backed securities are hard to find, and Fitch's abstracts are a significant improvement over previous descriptions. We applaud Fitch for their efforts to bring more transparency to this often murky market.
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* Access to the abstract is free, but you will need to create an account with Fitch.
Monday, May 20, 2013
Options Strategies Embedded in Exchanged Traded Products
By Tim Dulaney, PhD and Tim Husson, PhD
In theory, exchange traded products (ETPs) can be linked to almost any underlying asset, including derivatives. While many ETPs are linked to portfolios of bonds or stocks, some are linked to portfolios of futures contracts, which we have discussed at length before. Bill Luby at VIX and More has written a couple posts on ETPs that are linked to portfolios of options, which are gaining some traction with investors. As usual, we greatly enjoyed Bill's posts and thought we'd explain some of the mechanics behind the option strategies embedded in these ETPs. More information about the basics of options can be found here.
The first strategy we'd like to talk about is referred to as a "covered call" or "buy-write". This is the strategy implemented by PowerShares S&P 500 BuyWrite ETF (PBP), iPath CBOE S&P 500 BuyWrite Index ETN (BWV), Credit Suisse Gold Shares Covered Call ETN (GLDI) and, most recently, Credit Suisse Silver Shares Covered Call ETN (SLVO). In options parlance, a covered call refers a position that is both long some asset and short a call option on that asset: the short call is 'covered' by the long position in the underlying asset. The figure below explains the profit and loss of this combined position graphically.
In theory, exchange traded products (ETPs) can be linked to almost any underlying asset, including derivatives. While many ETPs are linked to portfolios of bonds or stocks, some are linked to portfolios of futures contracts, which we have discussed at length before. Bill Luby at VIX and More has written a couple posts on ETPs that are linked to portfolios of options, which are gaining some traction with investors. As usual, we greatly enjoyed Bill's posts and thought we'd explain some of the mechanics behind the option strategies embedded in these ETPs. More information about the basics of options can be found here.
The first strategy we'd like to talk about is referred to as a "covered call" or "buy-write". This is the strategy implemented by PowerShares S&P 500 BuyWrite ETF (PBP), iPath CBOE S&P 500 BuyWrite Index ETN (BWV), Credit Suisse Gold Shares Covered Call ETN (GLDI) and, most recently, Credit Suisse Silver Shares Covered Call ETN (SLVO). In options parlance, a covered call refers a position that is both long some asset and short a call option on that asset: the short call is 'covered' by the long position in the underlying asset. The figure below explains the profit and loss of this combined position graphically.
The covered call strategy generates income by selling call options (thus earning the option premium), but in doing so misses out on any increase in the value of the asset above the call strike. This strategy is particularly effective in markets without significant appreciation (since the investor would miss out on said appreciation) or depreciation (since the option premium would provide little protection against losses). Generally speaking, the closer the strike price is to the current asset price, the more income is generated and more upside potential is lost.
Another closely related strategy that has been implemented in ETPs is the put-write strategy. One ETP that implements this strategy is the ALPS US Equity High Volatility Put Write (HVPW). You might have noticed that the covered-call strategy looks very much like a short put option. Well, that is the essence of the put-write strategy. The strategy sells put options and profits when the put options expire worthless. This strategy has gained significant attention since the CBOE began publicizing the PUT index (noting that the PUT index returned a staggering 1150% compared to the S&P 500 returning 800% between 1986 and 2012).
What makes these ETPs interesting is that it gives investors a way to invest in moderately complex option strategies without really understanding their mechanics. If an investor wanted to implement a covered call on their own, they'd have to worry about when (and how) to sell the call, when to cover the short position and rolling the position forward periodically (repeating this process all over again). ETPs wrap this process up into (a perhaps too easily) digestible package.
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