## Tuesday, January 31, 2012

### Did BoA’s 2007 CLOs Defraud Investors?

By Olivia Wang, PhD

We have posted a new paper today showing that on July 2007 Banc of America appears to have transferred at least $35 million of previous losses to unsuspecting investors in two of its CLO offerings – LCM VII and Bryn Mawr II (the preliminary pricing memoranda for these deals are available for download here, and here, respectively). Investors ultimately lost nearly$150 million in October 2008 when these two CLOs backed by leveraged loans were liquidated.

Leveraged loans issued to below investment grade corporations were frequently extended by a syndicate of lenders intending to re-sell participations in the loans to other banks and institutional investors including hedge funds, mutual funds and CLO trusts.

LCM VII’s capital structure is illustrated in Table 1.

Banc of America bought or financed the $400 million face value portfolio of loans for LCM VII at above par between November 2006 and June 2007.[1] By the time LCM VII was issued on July 31, 2007, the portfolio had already lost 5% and the lowest tranches were nearly worthless before Banc of America Securities sold them to investors. Just like this, Banc of America transferred$20 million in losses suffered on a portfolio of loans it held before the closing to uninformed investors who bought LCM VII’s lower priority notes. In addition, since the credit support typically provided by the lower tranches was consumed by undisclosed losses prior to July 31, 2007, investors in the more senior tranches were sold much more risky securities than the offering documents portray and were promised much less compensation than informed investors in those tranches would have demanded.

In late July 2007, Banc of America also sold Bryn Mawr CLO II backed by loans Banc of America bought at above par earlier in 2007. The loans which ended up in Bryn Mawr II’s portfolio had already lost approximately 3.5% or $15 million by July 26, 2007 when Banc of America sold this CLO to investors. This allowed Banc of America to transfer$15 million in losses suffered on a portfolio of loans it held before the closing to uninformed investors who bought Bryn Mawr II notes.

In October 2008 both LCM VII and Bryn Mawr II failed market value tests and were subsequently liquidated. Investors in the low tranches in each deal lost approximately $75 million. These losses would not have occurred but for Banc of America’s failure to inform investors in July 2007 of the losses that had already occurred. [1] LCM VII Private Placement Memorandum, p. 13. Updated 2012-02-01 Yesterday, a FINRA arbitration panel in Reno, NV ordered Banc of America Securities to pay an investor who bought the E-1 Notes in LCM VII,$1.375 million including $251,668.74 in interest,$218,344 in attorneys' fees and $23,500 in expert witness fees. The award was made after a hearing in which the Claimant alleged that Respondents violated Nevada’s securities fraud statute (NVS 90.570) by failing to disclose that losses in the loans backing the CLO prior to the issuance of the CLO were being transferred to the CLO investors and would make the CLO notes much less valuable and much more risky. Dr. McCann testified on behalf of the Claimant. ### Oppenheimer Ordered to Repurchase$5.98 Million in Auction Rate Securities

By Tim Husson, PhD and Olivia Wang, PhD

In January 2012, a Financial Industry Regulatory Authority arbitration panel in New York ordered Oppenheimer to repurchase certain Auction Rate Securities sold to Claimant Nicole Davi Perry for $5.98 million, plus payment of$134,108 in legal fees. The award was posted in FINRA’s arbitration database this Monday. For a related report from Reuters, please see here. Dr. O’Neal at SLCG testified on behalf of the Claimant; Dr. O'Neal and Dr. McCann have authored a report on ARS previously.

Auction rate securities are usually issued by municipal agencies, mutual funds and structured trusts. They are always traded at par in periodic auctions. The interest rate paid over a coupon payment period is determined in an auction at the beginning of that period, but subject to a cap, often called the ‘maximum interest rate.’ Beginning in 2007, when investors started to demand more compensation than the maximum interest rate for increased credit and liquidity risk, auctions began to fail. This made the value of many Auction Rate Securities drop significantly.

Despite this possibility for auction failures, ARSs were still marketed by many broker-dealers, including Oppenheimer, as safe, liquid short-term investments, comparable to money market funds or certificates of deposit. This is simply not true. In September 2007, two months after Oppenheimer purchased around $6 million in municipal ARS for the Claimant, Financial Week reported that at least 60 auctions had failed in the preceding weeks, representing as much as$6 billion, or 2% of the ARS market. Interestingly, between December 1, 2007 and February 12, 2008, Oppenheimer CEO and Chairman of the Board Albert Lowenthal sold his personal holdings of ARS in the amount of $2.7 million. (Details about this could be found in the Administrative Complaint, Massachusetts Securities Division, 11/18/2008) On February 28, 2008, the New Jersey Turnpike Authority Turnpike Revenue ARS Bond sold to Claimant Nicole Davi Perry failed in its auction and never had a successful auction again. Although the ARS was sold to the claimant as short-term liquid asset, its maturity date was January 1, 2030, and after the auction failure, was completely illiquid. This case highlights many of the issues surrounding auction rate securities that remain even after the market-wide auction failures in 2008. Estimates of the market size at that time suggest that over$300 billion of auction rate securities were outstanding at that time, most of which will not mature for many years.

## Monday, January 30, 2012

### Freddie Mac, complex derivatives, and one huge conflict of interest

By Tim Husson, PhD and Tim Dulaney, PhD

There have been many news reports lately describing the difficulty homeowners have had in refinancing their mortgages. Many decry the strict requirements imposed on them by Fannie Mae and Freddie Mac, the massive taxpayer-owned-but-ostensibly-nongovernmental mortgage financing firms. Well today, NPR and ProPublica are reporting that Freddie Mac bet billions that many homeowners would not be able to refinance their mortgages.

Now that's a conflict of interest.  Other outlets have begun to report the story as well, for example see here and here.

The article says the bet was on inverse floaters:
In 2010 and '11, Freddie purchased $3.4 billion worth of inverse floater portions — their value based mostly on interest payments on$19.5 billion in mortgage-backed securities, according to prospectuses for the deals. They covered tens of thousands of homeowners. Most of the mortgages backing these transactions have high rates of about 6.5 percent to 7 percent, according to the deal documents.One portion is backed mainly by principal, pays a low return, and was sold to investors who wanted a safe place to park their money. The other part, the inverse floater, is backed mainly by the interest payments on the mortgages, such as the high rate that the Silversteins pay. So this portion of the security can pay a much higher return, and this is what Freddie retained.
Between late 2010 and early 2011, Freddie Mac’s purchases of inverse floater securities rose dramatically. Freddie purchased inverse floater portions of 29 deals in 2010 and 2011, with 26 bought between October 2010 and April 2011. That compares with seven for all of 2009 and five in 2008.
In these transactions, Freddie has sold off most of the principal, but it hasn’t reduced its risk.
First, if borrowers default, Freddie pays the entire value of the mortgages underpinning the securities, because it insures the loans.
It’s also a big problem if people like the Silversteins refinance their mortgages. That’s because a refi is a new loan; the borrower pays off the first loan early, stopping the interest payments. Since the security Freddie owns is backed mainly by those interest payments, Freddie loses.

The article also claims Freddie "says its traders are 'walled off' from the officials who have restricted homeowners from taking advantage of historically low interest rates by imposing higher fees and new rules." But clearly, the investment side must have known that the amount of refinances and prepayments would be low enough to make this position profitable.  As others have reported, this position could be a hedge against the high sensitivity to interest rate fluctuations.

The taxpayer owned company with great power over whether or not a significant portion of US homeowners have the ability to refinance their mortgages has been making investments that are profitable precisely when homeowners are not able to refinance their mortgages.  If Freddie Mac had taken the other side of the bet, their investment strategy would at least be consistent with their stated mission of 'making home possible'.

At the very least, this position does not bode well for Freddie Mac's credibility or shareholder transparency.   In general, Freddie Mac can't be both a profit-maximizing corporation and a special purpose entity with a specific governmental policy initiative.  Examples like this show that one goal must be exclusive to the other.

We'll be watching this one very closely.

## Thursday, January 26, 2012

### President and CIO of Direxion admits that leveraged ETFs are not appropriate for most investors

By Tim Husson, PhD

Today Seeking Alpha posted an interview with Dan O'Neill, President and CIO of Direxion, one of the first and best known issuers of leveraged ETFs. Readers familiar with our work on leveraged ETFs (see post here, paper here) know that we feel these products are almost always unsuitable for retail investors.

Surprisingly enough, Mr. O'Neill agrees completely:
The leveraged indexed ETFs are used by very tactical investors, and so there we have bull and bear funds. They have daily betas, which means that essentially they’re to be used by people expressing a very short-term view of the markets.

They’re not appropriate for investors. You have to have the right attention span and risk tolerance, and essentially, they’re good for traders. They’re not really good for investors.
We couldn't agree more. He adds later:
I think that most market participants should not use these products…and I’m not sure what the proper number is, but let’s just say 95% of market participants should not use these sorts of products. Because they’re looking to invest for longer than the timeframe for these sorts of products.
In fact, the distinction he draws between traders and investors is a useful one. Traders with an opinion on short term (really, single day) movements can use leveraged ETFs to accelerate those returns, which may be easier to buy and sell than options. But due to the compounding effects we and others have noted for years, these are not products that should be bought and held for any extended period of time.

Despite increasingly explicit disclosures, educational resources from issuers (such as these from ProShares), and statements such as the above, we still very often see brokers fill investors' portfolios with leveraged ETFs and other complex products. Fortunately, the consensus seems to finally be swinging in the right direction.

## Tuesday, January 24, 2012

### Interest Rate Swaps

By Tim Dulaney, PhD

In this blog post, we will discuss a particular kind of over-the-counter (OTC) derivative instrument called interest rate swaps. This post is meant as a broad stroke and an introduction to interest rate swaps. In the future, we plan to have additional posts about specialized interest rate swaps, case studies of particular interest rate swaps and on the pricing of interest rate swaps.

Interest rate swaps are customizable bilateral (involving two parties) agreements wherein one party exchanges a series of cash flows based upon one (possibly floating) interest rate for another (possibly floating) interest rate. The party that takes the opposite position in the agreement is referred to as the “counterparty”. The interest payments each party is to receive are based upon the same principal amount – called the “notional”. At each payment/settlement date, the interest payments are netted and only the party that has agreed to pay the higher interest payment makes a payment.

Interest rate swaps have become increasingly popular over the past several years. The aggregate notional amount of interest rate swaps within developed countries has grown from less than $50 trillion in June 1998 to more than$500 trillion in June 2011. The following figure was produced using data compiled by the Bank for International Settlements.

Total Notional Amount of interest rate swaps within G10 countries and Switzerland between June 1998 to June 2011.

Interest rate swaps can be used for a number of purposes. Institutions use swaps to ensure that income payments better match the required payments for their liabilities. Swaps can also be used as a hedge against rising interest rates. For example, if a municipality has floating rate debt and is concerned about the possibility of rising interest rates then an interest rate swap could transform this liability into a fixed-rate obligation. In addition, an interest rate swap can be used to change an entity’s sensitivity to interest rate changes – called duration. The floating rate leg of the interest rate swap has shorter duration and therefore the value of the agreement to the floating-rate receiver is more sensitive to interest rate changes.

Interest rate swaps are usually structured so that neither side has an advantage at the beginning of the agreement – ignoring fees attached to the agreement by the financial intermediary structuring the agreement. This process involves projecting future cash flows for each party and then making sure the present value of the two party’s cash flows are equal. As interest rates change over time, the agreement becomes an asset for one party and a liability to their counterparty.

There are significant risks associated with using these derivative products. For example, although swapping a floating rate for a fixed rate can change a floating-rate obligation to a (synthetic) fixed-rate obligation, the continued success of the agreement depends upon the counterparty’s ability to hold up their end of the bargain. There is also the possibility that one party could terminate the agreement when the contract has a negative fair value for the counterparty. In this situation, it is possible that a large payment would be required to compensate the terminating party for the value of the agreement.

Interest rate swaps are powerful financial instruments that can be used for good or evil. It is important to consider fully the risks associated with the investment decision since these choices will have a profound fiscal impact for years to come.

## Monday, January 23, 2012

### FINRA Regulatory Notice: Complex Products

By Tim Husson, PhD

FINRA recently released Regulatory Notice 12-03: Heightened Supervision of Complex Products, outlining their increased scrutiny of a wide variety of alternative investments including structured products, inverse or leveraged exchange traded funds, and asset-backed securities. Here at SLCG, we’ve done research on each of those subjects, and have a variety of ongoing projects that bear directly on the issues highlighted by the Notice.

The products identified include:

• Asset-backed securities and non-traded REITs;
• CMS-rate linked structured products;
• ‘Steepener’ and ‘flattener’ products;
• Reverse convertibles
• Range accruals;
• ‘Worst-of’ structured products, whose payoff is linked to basket of securities;
• Products linked to complex indexes such as the VIX
• Principal protected notes
• Leveraged and inverse ETFs,
• Other products with complex payoff formulas.
Our research strongly supports the notion that these products demand increased scrutiny by both regulators and investors themselves, as we have documented numerous examples of overpricing and complex risk factors. The FINRA Notice recognizes the need for proper due diligence, broker and investor education, internal controls, and extensive suitability analysis before selling these products to retail investors. It is our opinion that structured products are virtually never suitable for unsophisticated investors; however, we hope the FINRA Notice will at least increase standards for selling these products in the retail market.

## Sunday, January 22, 2012

### WSJ on the 'sophisticated investor' defense

By Tim Husson, PhD

The Wall Street Journal's Financial Advisor blog has a new article on the 'sophisticated investor' defense in securities litigation. This defense is typically used by defendants (usually banks or investment houses) in response to claims against them related to suitability of complex investment products. It boils down to the assertion that because a claimant has a high net worth, he or she is capable of understanding and willing to assume the risks of even extraordinarily complex strategies. From the article:

Regulators require that an investor have a certain amount of wealth–$1 million, for example–to be able to purchase certain complicated securities. But “money and sophistication are not synonymous,” says John Lovi, a securities litigator and founding partner of Steptoe & Johnson’s New York office. He uses reality television star Kim Kardashian as an example: She may have more than enough money to be considered an accredited investor by the Securities and Exchange Commission, but that doesn’t mean she is sophisticated about investing, he notes. The basis for this defense comes from the SEC's definition of accredited investors, which defines to whom investment houses can sell certain types of risky investments. These investments typically qualify for what is known as a Regulation D exemption, meaning they do not have to submit detailed financial information to the SEC in the interests of disclosure. This of course means that often very little is known about these investments, analyst coverage is poor or non-existent, and that the products would not likely be successful in a transparent marketplace with full disclosure. At SLCG we encounter suitability issues in a wide variety of securities litigation cases, including cases where the claimant was wealthy but not financially sophisticated. We think it's encouraging that FINRA arbiters often make this distinction, even if their regulatory framework does not, but in the long term the best solution is probably to revise the regulations themselves to correct this simple logical error. ## Saturday, January 21, 2012 ### Futures-Based (Commodities) ETFs By Tim Dulaney, PhD Investors may think, when investing in Futures-Based Commodities exchange traded funds (ETFs), that they are gaining exposure to the underlying commodity. In this blog post, we discuss the ability of these ETFs to track the spot price of the underlying commodity. In a previous blog post, we introduced the basics of Exchange Traded Funds (ETFs). In this post, we are going to discuss a specific kind of ETF: Commodities Futures Based ETFs. There are a large number of Exchange Traded Funds (ETFs) on the market today that purport to offer investors exposure to a commodity, whether it is gold (e.g. GLD), crude oil (e.g. USO) or crops (e.g. DBA). There are many reasons an investor might want exposure to the price changes of a commodity. Equity investors can decrease the volatility of their portfolio by allocating a portion of their investments to commodities without decreasing expected returns. This is due to the negative correlation between equity returns and the returns of commodities futures contracts. Another reason is that the price of commodities is positively correlated with inflation. So an investor concerned about the buying power of their money might invest in commodities as a hedge against the inflationary deterioration of their money. ETFs make gaining exposure to commodities easier for retail investors when compared to conventional methods. The first commodity ETF in the U.S. was State Street’s SPDR Gold Trust ETF (GLD) issued on November 12, 2004. In the figure below, we show the total amount of funds invested in commodities ETFs from March of 2006 to September 2011. Asset Value of Commodities ETFs Commodities ETFs obtain exposure to those markets not through purchasing the physical assets (since the storage of most commodities is impractical) but through futures contracts, which involve complex “rolling” strategies. An investor that wants exposure to commodities in his or her portfolio will likely buy futures contracts, either directly or indirectly. Since all futures contracts have expiration dates, an investor will have to replace an expiring contract that he or she owns with a new contract that expires later, a process known as “rolling-over”. Essentially if the contract you’re replacing is sold for less than the contract you’re buying, you are losing some of the return associated with change in the spot price of the underlying commodity. As a result of these rolling strategies, these ETFs show substantial deviations from the returns investors might expect or intend when they purchase them. Retail investors might assume that those ETFs track the spot price of a commodity itself, such that when the price of oil (or silver, or wheat) rises or falls, the ETF’s value will rise or fall a proportional amount. This potential for misunderstanding could lead to substantial losses, especially since most of these ETFs grossly underperform the spot prices of their underlying assets. For more details about commodities ETFs and an analysis of the mechanism that leads to the departure from naïve expectations for returns, see the following paper. SOURCE: Bloomberg L.P. ## Friday, January 20, 2012 ### NY Times on the Hosier decision By Tim Husson, PhD The New York times has an article about the MAT and ASTA products sold by Citigroup that were the subject of a$54.1 million award in Denver last April. SLCG provided expert testimony and analysis for the claimants in this case, including assessing the MAT/ASTA products at issue, and we are excited that the Times has drawn attention to these highly risky investments.

The MAT and ASTA products were hedge funds that implemented a leveraged municipal bond arbitrage strategy. Essentially, these funds tried to capture the small difference in yields between municipal and Treasury notes. Since this spread was small, they leveraged their exposure to generate substantial returns. Their fundamental assumption was that muni bonds yield more than Treasury notes because of market inefficiencies, and that the difference was an arbitrage strategy. They were wrong.

As our previous research has shown, the higher price of municipal bonds is not an arbitrage opportunity, but is a result of the call features that exist in municipal but not Treasury bonds, as well as liquidity and credit risk. In fact, when these funds failed, it was not even due to extraordinary market events, but normal market fluctuations combined with their high degree of leverage.

The MAT and ASTA products were not the only implementation of ‘muni arb’ strategies in the mid-2000s, but were often marketed in misleading ways, as detailed in the Times article. We have encountered several breeds of muni arb products, almost all of which failed around the same time and for the same reasons. We believe it is critical for investors to know that these strategies were extremely risky and were based on a false assumption that flew in the face of decades of financial theory and research.

Kudos to the NY Times for calling attention to this important issue!

## Wednesday, January 18, 2012

### Leveraged ETFs

By Tim Dulaney, PhD

Leveraged Exchange Traded Funds (ETFs) are some of the most popular exchange-traded vehicles and (as a result) are liquid, widely available, and very likely to be on the radar screen of even casual investors.

In a previous blog post, we introduced the basics of ETFs. In this post, we are going to discuss a specific kind of ETF: Leveraged ETFs. This post is part of a two-part series. The next post will concern a related instrument called Inverse Leveraged ETFs.

A Leveraged ETF offers investors a daily return that is a multiple of the daily return of the index or asset tracked by the ETF. For example, a 2x leveraged ETF that tracks the S&P 500 index (SPX) would return 2x the daily return of the SPX. So if SPX exhibited a return (loss) of 10%, then an investor in the fund would see a return (loss) of 20%.

The first leveraged ETF was released by ProFunds in June 2006 and the number of funds has grown dramatically over the past half-decade (SOURCE: Bloomberg L.P.).

Number of (US Domiciled) Leveraged ETFs from 2006 to 2011

An important piece of information investors in leveraged ETFs need to be aware of is the effect of rebalancing. Rebalancing can best be explained by example. Let’s say an investor uses $200 to buy some asset ($100 her own money and $100 borrowed) so that she is 2x leveraged. If the asset increases in price by 10%, the investor now has$120 after she returns the borrowed funds (assuming her friend doesn’t charge interest). In order for our investor to have 2x exposure to the asset for the following day, she must rebalance her account so that the total amount invested is twice her investment (she must borrow $20 more dollars). After she borrows$20 more from her friend, she now has $240 invested in the asset and$120 net equity (regaining her 2x exposure).

Leveraged ETFs must rebalance on a daily basis since at any time an investor could buy the fund and at that point the ETF needs to be of the appropriate leverage. The effects of rebalancing on buy-and-hold investors compound over time and lead to substantial deviations from expectations. We present the following table as an example of the compounding effect of rebalancing.

Hypothetical Scenario Illustrating the Effect of Rebalancing
Notice that the underlying asset has not appreciably changed in price ($0.01 five day return); however, the net equity value in the 2x Leveraged ETF experienced a 20% decrease. The take-away message from this is that buy-and-hold investors should not invest in leveraged ETFs unless they understand the risks associated with daily rebalancing. Proshares discusses the rebalancing issue in some detail here and here. For further reading on this topic, we suggest taking a look at our paper on the effect of rebalancing on investors in ETFs. ## Tuesday, January 17, 2012 ### Inverse ETFs Inverse exchange traded funds (ETFs) are, by most measures, just as popular and liquid as their leveraged counterparts. In this post we discuss the rebalancing and tracking behavior of these ETFs. This is the second part of our two part series. Last time we discussed leveraged Exchange Traded Funds (ETFs). In this post, we are going to discuss a related kind of ETF: Inverse ETFs. An Inverse ETF offers investors a daily return that is opposite of the daily return of the index or asset tracked by the ETF. For example, an inverse ETF that tracks the S&P 500 index (SPX) would return the inverse of the daily return of the SPX. So if SPX exhibited a return (loss) of 10%, then an investor in the fund would see a loss (return) of 10%. Since their introduction in 2006, the number of inverse ETFs has grown quickly over the past five years. Number of (US Domiciled) Inverse ETFs from 2006 to 2011 Just as with leveraged ETFs, investors interested in inverse ETFs need to be aware of is the effect of rebalancing. Following the previous post in the series, we will explain rebalancing by example. Let’s say an investor has$100 cash and shorts $100 of some asset (giving her$200 cash and a -$100 position in the asset). If the asset increases in price by 10%, the investor now has$90 net equity. In order for our investor keep her inverse exposure to the asset for the following day; she must rebalance her account so that the total amount invested is equal to the short position in the asset. To keep her inverse exposure, she must take $20 of her cash to buy a share of the underlying asset. The resulting position is$90 net equity with a -$90 position in the asset. Inverse ETFs must rebalance on a daily basis since at any time an investor could buy the fund and at that point the ETF needs to be of the appropriate leverage. The effects of rebalancing on buy-and-hold investors compound over time and lead to substantial deviations from expectations. We present the following table as an example of the compounding effect of rebalancing. Hypothetical Scenario to Illustrate Effect of Rebalancing Notice that the underlying asset has (basically) not changed at all in price; however, the net equity value in the inverse ETF experienced a 18% decrease. The take-away message from this is that buy-and-hold investors should not invest in inverse ETFs unless they understand the risks associated with daily rebalancing. Although we have only discussed in detail -1x (Inverse) ETFs here, there are also many inverse leveraged ETFs on the market that offer investors multiples of the inverse daily returns of an underlying index or asset. Proshares discusses the rebalancing issue in some detail here and here. For further reading on this topic, we suggest taking a look at our paper on the effect of rebalancing on investors in ETFs. SOURCE: Bloomberg L.P. ## Friday, January 13, 2012 ### Introduction to ETFs By Tim Dulaney, PhD Exchange-traded funds (ETFs) are investment funds that are listed on a major stock exchange and typically track some underlying security, index, commodity, or other asset. ETFs, like mutual funds, are often designed to track assets that are otherwise difficult to purchase individually or in small amounts, such as an index or commodity. Compared to mutual funds, ETFs are characterized by generally lower fees and higher liquidity because ETFs are traded on major market exchanges. In addition, it is much easier for retail investors to purchase ETF shares rather than attempt the complicated and cumbersome process of achieving similar exposure themselves. ETFs enable retail investors to purchase exposure to a wide variety of asset portfolios and investment strategies with relatively small investments. Many ETFs have been tailored to offer highly specific return characteristics for different investment objectives (good example here). Put simply, ETFs make sophisticated investment strategies easy and accessible. This does, however, mean that retail investors can use ETFs to achieve exposure that would be deemed unsuitable if purchased through the underlying asset itself. For example, a 3x leveraged ETF borrows 200% of the equity in its portfolio (put differently, equity represents only 33% of the portfolio value). It is highly unlikely that a retail investor would be able to achieve this leverage in a retail margin account, for both regulatory and suitability reasons. Therefore ETFs can be used to sidestep market regulations and enable retail investors to take otherwise prohibited positions. This potential suitability issue has gained the attention of both FINRA and the SEC. FINRA’s Notice to Members on non-traditional ETFs warns that “while such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis.” Likewise, the SEC released an Investor Alert “because [they] believe individual investors may be confused about the performance objectives of leveraged and inverse exchange-traded funds.” It is clear that investors must understand the specifics of complex ETFs, and that their particular risks must be clearly disclosed. Exchange Traded Notes (ETNs) are in many ways similar to ETFs. ETNs trade on major stock exchanges and generally seek to track some index or commodity. In some sense, ETNs are to ETFs as bonds are to stocks. Although the value of an ETN depends upon the underlying asset to which it is linked, the value also depends on the credit quality of the issuer. This means that even if the asset being tracked by the ETN does not change in value, a decrease in the credit quality of the issuer will decrease the value of the notes. Unlike ETFs, but similar to bonds, ETNs mature and are basically debt instruments of the issuer. Futhermore, ETNs do not actually hold the underlying asset while ETFs do. ETFs seek to track the returns of a given index or asset, but ETNs simply promise the returns of the index or asset. In future blog posts, we will talk specifically about a few types of ETFs (for example, Leveraged, Inverse Leveraged and Futures-Based ETFs). ## Monday, January 9, 2012 ### Structured products: 2011 year-end market review By Tim Husson, PhD 2011 was another big year for structured product sales both in the US and abroad. According to Bloomberg’s year end totals, almost$45.5 billion worth of SEC registered structured products were sold in the US in 2011, down only slightly from $49.4 billion in 2010. There were 7,293 individual products sold, up from 6,443 a year earlier. The number of products linked to interest rates decreased, which was made up for with increases in products linked to equity assets. Sales in Europe grew substantially, with a total volume of$101.8 billion, over \$82.6 billion in 2010. Interestingly, the number of deals fell slightly from 4,742 to 4,406: it seems that structured products are on average smaller in the US and that the difference is growing.

Also interesting is that several product features have become more popular over time. It seems that in the US, autocallable products have become much more popular in recent years, whereas principal protection notes have fallen off, and those tied to baskets of underlying securities have waxed and waned but taken off recently.

Structured products are an active area of research at SLCG, and we now have a variety of research papers on important structured product issues. We also have a database of structured product valuations, available for free at http://slcg.com/products.php. We will continue to closely monitor the structured product market, as it is one of the most innovative financial markets today.

SOURCE: Bloomberg L.P.

## Wednesday, January 4, 2012

### What are 'structured products', anyway?

By Tim Husson, PhD

We've done a lot of work on structured products.  And I mean a lot.  In addition to our research on valuation and suitability issues, we've devoted a section of our website to informing investors about different types of products, as well as Tear Sheets evaluating several thousand structured products released over the past couple years.  We have found that most structured products are issued at a substantial premium, and that many investors (especially retail investors) do not fully understand these products, which very often wind up in FINRA arbitrations or worse.

But you might be wondering, what exactly is a structured product? or, how could such a complex investment be available to retail investors?  The answer--like the product--is complex.

Structured products are ultimately corporate debt.  Each structured product is treated as a corporate bond, with a specific stated maturity and payoff, for regulatory purposes.  Banks that issue structured products submit a the same registration form (Form 424B2) to the SEC as they would for other forms of corporate debt, and are ultimately responsible for the promised payouts in the same way as they are responsible to common debt holders.

[Interestingly, many exchange-traded products are also structured as corporate debt, and are typically referred to as Exchange-Traded Notes (ETNs) as opposed to Exchange-Traded Funds (ETFs).]

This simple point actually reveals an important factor that is often overlooked by investors.  The value of structured products is strongly affected by the credit risk of the issuing bank.  If a bank (let's call it 'Lehman Brothers') issues a wide array of structured products at a particular point in time (say, 2007-2008), then the value of those structured products depends on the probability that that bank will not be able to pay its obligations as they fall due.  It is very important that structured product valuations include this credit risk adjustment, because the many investors who bought Lehman's structured products in 2008 received almost nothing when that bank went bankrupt and the probability of that default was high when the products were issued.

Since structured products are just corporate debt, they can have almost any arbitrary payoff function.  Typically banks issue products which are easily hedged, such as simple combinations of equity and derivatives, but can also link payoffs to interest rates, commodities, and other asset classes.  Also, because of their status as debt and their SEC filings, they can be purchased by retail investors and sold through brokers.

Structured products have become a huge market (despite the financial crisis) and many educational resources are available in addition to our preferred source.  Bloomberg subscribers have access to the Bloomberg Structured Notes Brief, which is a weekly source of objective news and analysis based on Bloomberg's extensive database of products both in the US and abroad.  More from the financial industry's point of view, Risk.net publishes a magazine devoted to structured products (aptly named Structured Products), and the Structured Products Association has an informative website.

Our longstanding and ongoing research demonstrates that structured products are highly complex and often overpriced, and we believe investors should very carefully consider a wide variety of factors (and alternatives) before purchasing these types of products.  However, we encourage you to peruse our own and other sites' materials, as it is very important that both investors and the public become aware of this very large and very innovative market.

## Sunday, January 1, 2012

### Welcome to the new SLCG blog

By Craig McCann, PhD, CFA

At SLCG we encounter a lot of complex investment strategies and interesting financial products. We have traditionally written up our findings into research articles and published them in peer-reviewed academic journals, but lately we’ve realized that there are too many interesting topics to devote an entire research project to each and every one.

We support the dissemination of information that can inform and educate everyday investors of both old and new financial products.  It would be simply impossible for us to do this in a timely manner at the slow pace of academic research and publishing.  We strive to be investor advocates and the most efficient way to reach a larger group of people this day and age is to write a living document containing pertinent information for today's investor.

As a result, we have decided to venture into the blogosphere with the hope of providing a broader coverage of the financial world and interacting more directly with our readers. We hope this blog can become a valuable resource for investors, brokers, lawyers, and other financial practitioners.  We also hope the blog encourages active and lively discussions that seek to educate the community at large.

Posts before this introduction form a collection of material previously contained on the commentary section of the SLCG website.  We include this information here (back-dated to the original date of composition) for completeness.

If you have subject suggestions for future blog posts, or perhaps just a simple question concerning finance that you'd like to have answered, send us an email. We will try to address your questions in a future blog post in an effort to educate the blogosphere at large.

Welcome to our blog!