Thursday, August 19, 2010

FINRA Press Release: Inverse Floating Rate CMOs

FINRA Fines HSBC $375,000 for Unsuitable Sales of Inverse Floating Rate CMOs to Retail Customers and Related Supervisory Failures

The Financial Industry Regulatory Authority (FINRA) issued a press release today announcing that 
it has fined HSBC Securities (USA) Inc. $375,000 for recommending unsuitable sales of inverse floating rate Collateralized Mortgage Obligations (CMOs) to retail customers. HSBC failed to adequately supervise the suitability of the CMO sales and fully explain the risks of an inverse floating rate or other risky CMO investment to its customers.
The settlement is detailed in the FINRA AWC No. 2007010582702.

FINRA found that HSBC failed to maintain adequate supervision on the sale of inverse floating rate CMOs. Supported by the recommendation of HSBC, 6 brokers sold 43 of these CMOs when such complex, high-risk securities were not suitable to customers who were considered unsophisticated, low-risk investors.

A mortgage backed security (MBS) is a debt security whose cash flows come from, and are backed by, the principal and interest payments of borrowers on the mortgage loans. The pooling of mortgages into a debt security is called securitization and is performed by a trust. Mortgages are originated by public and private agencies, they are then securitized into MBS by a trust, and then the MBS is issued to public investors by the trust. A collateralized mortgage obligation (CMO) is a type of MBS and is highly sensitive to interest rate changes – for example, in 1994 significant interest rate increases caused CMOs to fall in value.

SLCG has written a paper describing the market and history of CMOs in the wake of the collapse of Brookstreet Securities and two Bear Stearns hedge funds.

Wednesday, August 18, 2010

FINRA Press Release: Unit Investment Trusts

Merrill Lynch to Pay More Than $2.5 Million Related to UIT Sales Charge Discount Failures

The Financial Industry Regulatory Authority (FINRA) issued a press release today announcing that 
it has fined Merrill Lynch $500,000 for failing to provide sales charge discounts to customers on eligible purchases of Unit Investment Trusts (UITs). FINRA also found that Merrill Lynch failed to have an adequate supervisory system in place to ensure customers received appropriate UIT discounts. The firm also agreed to provide remediation of more than $2 million to affected customers.
The settlement is detailed in the FINRA AWC No. 2008015701301.

A Unit Investment Trust (UIT) is a type of investment company that holds a fixed amount of securities for a fixed amount of time. They are offered once during the initial offering. Since they are fixed at the outset, their portfolios are not traded actively. There are equity trusts and bond trusts. They have a termination date set at the initial offering. Upon termination, the equity trust is liquidated and distributed to trust holders at a net asset value. The bond trust, on the hand, will make periodic payments upon maturity when the funds are redeemed and redistributed to trust holders. Therefore, like mutual funds, UITs are bought back at NAV; but unlike mutual funds, UITs’ portfolios are fixed and hardly rebalanced throughout its term.

We remind investors to carefully understand a UIT before investing in it, and ask questions pertaining to the UIT’s portfolio, risks and risk management, investment objective and strategies, as well as any carefully weighing in the fees and expenses. UIT is just like any investment company and requires careful analysis before investing. Documents such as prospectus or statements of additional information are key sources to use for analysis.

Friday, August 13, 2010

In the News: Equity-Indexed Annuities

An annuity makes periodic payments to the holder of the annuity. Fixed annuities make fixed payments and variable annuities make variable payments. Equity-indexed annuities (EIAs) are similar to both fixed and variable annuities in that they pay an interest rate linked to an equity index and guarantee a minimum interest rate. EIAs are especially marketed to retirees by the insurance industry.

Forbes published an article on EIAs. The article evaluates the claims made by typical marketers of EIA and explains how such claims are either not true or should be heavily qualified. Dr. Craig McCann, founder of SLCG, is quoted in the article. He has written a paper called ‘An Economic Analysis of Equity-Indexed Annuities’ which argues that equity-indexed annuities are complex contracts whose true risks and costs are often obscured and that the lack of SEC oversight and regulation have resulted in ‘unscrupulous’ sales practices of equity-indexed annuities issuers.

Investors are welcome to visit our dedicated website here for other relevant papers and research.

SLCG Research: Leveraged ETFs

SLCG released today ‘Leveraged ETFs, Holding Periods and Investment Shortfalls’..

Exchange-Traded Funds is an investment fund that holds stocks, bonds, or commodities and typically tracks specific indices of such asset classes. Leveraged and inverse leveraged ETFs were first introduced to the market in June 2006 by ProFunds, which promiseds to return a multiple of the underlying index return by rebalancing their portfolios at the end of each day. The total market value of leveraged and inverse ETFs has grewrown from $1 billion in 2006 to more than $30 billion by 2010. FINRA has issued a Notice to Members and additional guidance whileand the SEC has issued an Investor Alert about leveraged and inverse ETFs.

In this paper we describe the problems associated with the daily rebalancing and the potential costs it may create for investors who hold these ETFs for longer than a few days. Further, we estimate the potential investment shortfall incurred by investing in these ETFs compared to investing in a simple margin account. We find that a substantial percentage of investors hold these ETFs for periods longer than one or two days, even longer than a quarter. Consequently, investors in leveraged and inverse leveraged ETFs can lose 3% of their investment in less than 3 weeks, an annualized cost of 50%.

Monday, August 9, 2010

In the News: Structured Notes

Structured Notes Are Wall Street's `Next Bubble,' Whalen Says

Bloomberg issued a news release today discussing the topic of a structured products bubble in Wall Street. According Christopher Whalen, managing director of Institutional Risk Analytics, the sale of structured products allows the selling firms to make bets on interest rates. Furthermore, they are illiquid products for which firms are not obligated to make markets and hence provide liquidity when these products might need them most.

This is consistent with our view that structured products are complex instruments that mask their hidden costs and risks. We encourage investors to carefully understand their payoff structures, associated fees, liquidity risks, interest rate risks and credit risks before committing to purchasing them. 

SLCG has a dedicated website providing papers, notes and calculation tools on a variety of structured products. Specifically, related papers include: