Wednesday, February 29, 2012

More SEC Charges Coming Related to MBS Disclosures

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.

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.

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:

Table 1


PIMCO Total Return Fund Institutional Class
Fidelity Cash Reserves Fund
SPDR S&P 500 ETF

Data as of
Data as of
Data as of
2/14/2012
2/22/2012
n/a
Ticker Symbol
PTTRX
FDRXX
SPY
Investment Amount
$10,000.00
$10,000.00
$10,000.00
Estimated Return You Selected
3.00%
3.00%
3.00%
Holding Period
10
10
10
Fund Value After 10 Year(s)
$12,834.99
$12,951.02
$13,318.76
Profit/Loss
$2,834.99
$2,951.02
$3,318.76
Total Fees & Sales Charges
$522.50
$422.25
$104.22
Total Fees
$522.50
$422.25
$104.22
Total Sales Charges
$0.00
$0.00
$0.00


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:
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.  

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)

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."

Thursday, February 23, 2012

Credit Risk in the Municipal Bond Marketplace

By Mike Yan, PhD and Tim Dulaney, PhD

Municipal bonds are debt securities issued by city, county or special-purpose government units (known as municipal authorities). This debt is typically issued to fund public works projects such as health care, construction projects or education. Because the interest from municipal bonds is usually exempt from federal income tax (one notable exception is Build America Bonds); the municipal bonds are especially attractive to high tax-bracket individuals. We will discuss some specifics of the tax-implications for municipal bonds (including state-level specifics) in a future blog post. In this post, we discuss the market yield of municipal bonds by comparing their yield to contemporaneously issued (taxable) Treasuries of the same maturity.

If issued at face-value, one would expect that the yield of high quality (AAA) municipal bonds should be close to the tax-adjusted Treasury yield of the same maturity: MuniYield = (1-TaxRate)*TreasuryYield. However, tax-adjusted Treasury yield is only the lower bound of the municipal yield. Empirically speaking, muni yields have traded much higher than the tax-adjusted Treasury yields. Sometimes, for example in late 2008 and 2011, the muni yields were even higher than the Treasury yields before tax-adjustments. In order to reflect the market yields, we use 20-year Moody’s Municipal Bond Yield averages (Bloomberg Ticker: MMBAAAA2 Index) for municipal bonds and use 20-year U.S. Treasury Yields (Bloomberg Ticker: C08220Y Index) for comparison with taxable bonds. The maturity of each municipal bond varies, and can be as high as 40 years. 
Does this phenomenon indicate an arbitrage opportunity? Our own Geng Deng and Craig McCann have shown that indeed there is no arbitrage opportunity. The difference of two yields, as explained in the same paper, can be explained by a combination of three factors: credit risk of the issuer, the embedded call option and the liquidity premium. We will discuss credit risk here, and the last two points in the forthcoming post.

Debt securities inherit credit risk from their issuers. The credit risk of municipal bonds issuers is higher than that of the U.S. government, for example. The compensation investors require for this risk is referred to as the (credit) risk premium. Before the financial crisis, the risk premium in some very high quality municipal bonds is almost zero. The financial crisis in 2007-2008 increased credit risk and amplified this premium even in the highest rated bonds. The sharp decrease of Treasury rates and sharp increase of the Moody rate around November 2008 reflects investors’ sentiment concerning the credit risk of the underlying debt. We cannot ignore this risk. Perhaps the most stunning example of this risk occurred in November 2011 when Jefferson County, Alabama filed for bankruptcy. This is the largest municipal bankruptcy in U.S. history and affects over $3 billion of municipal bonds issued by Jefferson County.

Although municipal bonds are risky, they are significantly less risky than similarly rated corporate bonds. According to Moody’s, the average 10-year historical cumulative default rate, from 1970 to 2009, for AAA municipal bonds is 0%, and rate for AA municipal bonds is 0.03%, comparing to 0.50% for AAA global corporates, and 0.54% for AA global corporates. In addition, the averaged recovery rate of municipal bonds, 59.91% for 30-day post-default period, is higher than those of corporates, 37.5%. The recovery rate denotes the fraction of the face-value that an investor will receive in the event of default (higher is better).

Regardless the fact that averaged risk of municipal bonds is lower than that of corporate bonds, one should still be mindful of the possibility of a municipality defaulting on their debt. If you believe the difference between municipal yield and the tax-adjusted Treasury yield can compensate you appropriately for the risks you’re shouldering, then a municipal bond could be a worthwhile investment. In addition, do not forget to discuss the potential tax benefits with a tax professional.

Wednesday, February 22, 2012

What is a Synthetic ETF?

By Olivia Wang, PhD

The total asset value in Exchange-traded funds (ETFs) has increased dramatically in recent years.  At the same time, ETFs have become more commonly associated with exotic features.  One such ETF (a synthetic ETF), also known as a swap-based ETF, tracks the return of a selected index (e.g. the S&P 500 stock index) using a total return swap. The use of derivatives such as total return swaps distinguishes a synthetic ETF from the physical ETFs on the market.  A complete list of synthetic ETFs offered on the Hong Kong stock exchange could be found here.

A physical ETF tracks an index in the most obvious way: owning the securities which constitute the index in the same portion as the index itself. The approach guarantees that the fund’s return will track that of the selected index if the transaction costs and a few other inefficiencies are ignored. However, this strategy will not work in all cases.  For example, imagine an ETF that is seeks to track the Russell 3000.  Owning all of the stocks underlying Russell 3000 index could be prohibitively expensive due to the trading cost and market illiquidity for many small cap stocks. This is where synthetic ETFs come into the picture. If all the fund needs is to buy the return with a total return swap, few indexes are off limits. We present the following graphical representation of the synthetic ETF:


In the chart, a total return swap is a contract between the synthetic ETF and a counterparty. The counterparty pays the ETF the precise return of the selected index in exchange for the interest payment on the collateral portfolio. In an unfunded swap, as depicted above, investors’ cash is used by the ETF provider to buy the basket of collateral. On the other hand, in a funded swap, investors’ cash is paid to the swap counterparty and the collateral is pledged to the ETF’s account held with a custodian. This means that the ETF does not legally own the collateral and when the counterparty defaults, the collateral might not be released to the ETF provider.

This brings us to the biggest potential downside of synthetic ETFs over physical ETFs: the heightened counterparty risk. When the swap counterparty defaults, the best investors could hope for is getting their share value back from the sale of the collateral. But this is unlikely for at least two reasons. First, the counterparty default usually happens in tumultuous market conditions.  As a result, even decent quality assets may suffer a substantial haircut due to lack of liquidity. Second, the type and the quality of the collateral involved in a synthetic EFT are often opaque. For example, there is no requirement that collateral must be of the same type as the underlying index the ETF tracks. In other words, a synthetic ETF tracking the S&P 500 may well hold European sovereign bonds in its basket of collateral. This lack of transparency renders synthetic ETFs especially dangerous for retail investors.

Tuesday, February 21, 2012

Stock Market Correlation and Portfolio Diversification

By Geng Deng, PhD, FRM and Olivia Wang, PhD

It has long been argued that diversification of stock portfolios across country borders is important to reduce investment risk. Although the 2007-2008 financial crisis wreaked havoc on both the developed and the developing world, diversification remains a central pillar of modern portfolio theory. The following figure from World Federation of Exchanges shows the value of several stock indexes starting from 1992 (Full Disclosure: No data available for Tehran SE/TEPIX in 2008, 2009 and 2010). The selected index as well as the stock exchange which publishes it is also listed.

        Figure1: Stock Index Levels between 1992 and 2010


The overall trend of the indexes is common: a relatively stable growth during 2002 to 2007, and a precipitous fall during the peak of the financial crisis. This pattern is more precisely reflected in the correlation of the annual returns of the seven indexes. Figure 2 shows the average of the pair-wise correlation computed using data from the previous ten-year-period for each given year. For example, the average correlation for year 2002 is obtained by first computing the correlation of annual returns of any two stock indexes from the seven indexes shown in Figure 1 over the period of 1993 to 2002. The average correlation is simply the arithmetic mean of all the pairwise correlations.

Figure 2: Evolution of Average Correlation



Starting from 2002, the average correlation increased from a moderate 0.25 to a striking 0.80. Globalization in both international trade and finance almost certainly contributes significantly to this increase (and correlations tend to increase during tumultuous periods such as 2007 and 2008). But if you believe that as the memory of the recent crisis fades away the global equity market will return to more tranquil period, diversification in your portfolio may still be an option worth exploring.

Interestingly, a recent NBER paper finds that even for investors who are supposed to be sophisticated enough to understand the complications involved in investing in the global markets, such as mutual fund managers, the degree of diversification is still not high. (A blog post written by the authors could be found here). In other words, the “Home Equity Bias Puzzle”, or “Lack of Diversification Puzzle” that has troubled economists for years is still present. The increased correlation of the global equity market will not completely explain this puzzle away, but at least it adds a new factor to the debate.

Monday, February 20, 2012

Déjà Vu: Non-Traded Business Development Companies

By Tim Husson, PhD

Last week we posted an introduction to non-traded REITs that highlighted the many risks inherent to those investments.  As it happens, another non-traded investment has been growing in popularity, but has an almost identical set of risk factors and has recently caught the attention of regulators:  non-traded business development companies (BDCs).

The resemblance between non-traded REITs and non-traded BDCs is uncanny.  Both are special business classes created by Congress in the mid 20th century, whereby investors can pool capital for investments in nonpublic entities and receive most of the BDC's taxable income back in distributions every year.  To qualify as a REIT, those investments must be real estate related; to qualify as a BDC, they are typically privately-owned companies.  While non-traded REITs have been marketed heavily for many years now, non-traded BDCs have only recently found a market:  according to InvestmentNews, non-traded BDCs raised just $94 million in 2009, but $369 million in 2010, and a staggering $1.5 billion in 2011.

Because both non-traded REITs and BDCs must file financial statements and offering documents with the SEC,  under US securities law they are allowed to be sold to retail investors through brokers despite receiving little to no analyst coverage or independent analysis.  Therefore it is up to the broker and investor--really, the investor--to analyze these SEC filings on his or her own, leaving substantial opportunity for misunderstanding and misrepresentation.  Unfortunately, as non-traded investments are almost totally illiquid, it is nearly impossible to get out of these investments.

Also like non-traded REITs, non-traded BDCs appear to maintain constant share prices, even with fluctuating net asset values.  Of course, just like real estate, the value of a non-traded BDC's holdings is difficult to value, as none of its assets have liquid market prices.  But investors should be extremely cautious in evaluating any purported lack of 'price volatility' or 'losses', as share prices are set arbitrarily by the issuer and do not reflect any market value.

Finally, both non-traded REITs and BDCs are sold at very high commission levels, often 7% or higher.  Therefore brokers have a strong incentive to push these investments onto unsophisticated investors; and, of course, only about 90 cents of every dollar invested is actually used to purchase assets.  Unfortunately, investors have been on their own when considering (or attempting to liquidate) their non-traded investments--hence, sites like REITWrecks--so we believe it is time that FINRA and the SEC at least take a closer look at these highly risky products.

[You can find prospectuses and other offering materials for an example non-traded BDC here.  This issuer--you guessed it--also offers several non-traded REITs.]

Friday, February 17, 2012

Did ARS Interest Payments Adequately Compensate Investors After the Failures?

By Carmen Taveras, PhD and Craig McCann, PhD, CFA

Auction Rate Securities (ARS) are floating interest rate debt issued primarily by municipalities, mutual funds, and special purpose trusts. ARS were marketed as short-term, cash-equivalent investments similar to commercial paper but any similarities with short-term investments were superficial and misleading. ARS are long-term debt traded in periodic auctions with prices fixed at par. The auction-determined interest rate was constrained by a maximum rate which could prevent the auctions from clearing.

Figure 1 plots the auction clearing rate (in blue) and the maximum allowable rate (in red) on The Gabelli Dividend & Income Trust Series E ARS. Prior to 2008, the clearing rate was always below the maximum rate and the auctions cleared. From early 2008 onward, there was not enough demand for this ARS at coupon rates below the maximum rate and the auctions failed. ARS issuers’ typically claim that investors have not suffered damages from the auction failures because the ARS continue to pay a coupon rate which as illustrated in Figure 1 is higher than short-term rates such as the yield on money market funds, the 91-day Treasury bill rate, or the 1-Month LIBOR.

                   Figure 1: Series E ARS issued by The Gabelli Dividend & Income Trust Fund




However, unlike the short-term investments used for comparison in Figure 1, ARS are subject to credit risk and liquidity risk. Short term rates such as the 91-Day T-bill rate, the 1-Month LIBOR, and the yield on the Vanguard Prime Money Market Fund are effectively risk-free rates – that is, for all practical purposes, a dollar invested can always be converted back to a dollar in cash at any time. The same cannot be said for ARS. After the auction failures, many ARS have traded only at substantial discounts to par. 

A better benchmark for ARS interest payments are the payments made on a security similar to the ARS. The Gabelli Dividend & Income Trust’s Series D preferred shares was issued on the same day as the Series E ARS; both are callable perpetual preferred stock. While Series E pays an auction-determined coupon rate, Series D pays a fixed coupon of 6% per year. Figure 2 shows Series E’s auction-determined interest rate and maximum rate and the yield-to-maturity on the nearly identical Series D. Series E always paid investors less than Series D and that difference became much greater after the auction failures.

     Figure 2: The Gabelli Dividend & Income Trust Fund Series D yields and Series E ARS coupons





Figure 2 illustrates a common theme we find in our posted ARS paper. ARS auctions failed in early 2008 because the maximum rates declined too far below what investors in truly similar securities were being paid. It didn’t take a credit crisis for these auctions to fail. All it took for was LIBOR to drop to levels as low as it had been as recently as 2005. (We have previously posted about ARS here and here).

SEC Litigation Releases: Week in Review

By Tim Dulaney, PhD

Court Enters Default Judgement Against SEC Defendant Daniel J. Burns and Orders Him to Pay over $1.1 Million, February 16, 2012 (Litigation Release No. 22260)

In their January 2011 complaint, the SEC filed a civil injunctive action against Daniel J. Burns and Robert F. McCullough, Jr. alleging that both defendants were guilty of insider reporting violations.  In addition, Burns allegedly "received hundreds of thousands of dollars in improper compensation and benefits from CytoCore[, Inc.] as an unregistered broker."  Burns submitted expense reimbursement claims based upon false information concerning investor solicitations. The final judgement orders Burns to pay over $1.1 million and "permanently bars him from acting as an officer or director of a public company."

SEC Charges Investment Adviser Brenda A. Eschbach with Multi-Year Misappropriation of Client Funds, February 15, 2012 (Litigation Release No. 22259)

The SEC filed a civil injunctive action against Brenda A. Eschbach "with securities fraud, investment advisory fraud, and acting as an unregistered broker-dealer."  The complaint (PDF) alleges that Eschbach issued inaccurate account statements and misappropriated client funds for personal expenses.   Eschbach has agreed to pay over $2.5 million pending the final judgement and the outcome of the criminal proceeding (U.S. v. Brenda A. Eschbach, 8:10-cr-00017-JVS (C.D. Cal.)).  Eschbach has plead guilty to mail fraud and money laundering and consented to the Commission Order essentially barring her from the financial services industry.

SEC Charges Venulum with Registration Violations in Connection with Offerings of Wine Contracts and Promissory NotesFebruary 15, 2012 (Litigation Release No. 22258)

The SEC charged both a British Virgin Islands company (Venulum Ltd.) and a Canadian company (Venulum Inc.) "with registration violations in connection with unregistered offers and sales of promissory notes and interests in fine wines."  The defendants agreed to the permanent injunctive action without admitting or denying the allegations.

SEC Charges California Hedge Fund Manager Connected to Galleon Insider Trading Case, February 10, 2012 (Litigation Release No. 22257)

The SEC filed a civil injunctive action against Douglas F. Whitman alleging that Whitman Capital had participated in insider trading.  Whitman allegedly traded on earnings information regarding two technology companies prior to the public announcement of these earnings and "reaped nearly $1 million in ill-gotten gains."  In particular, Whitman allegedly took a long position in Polycom Inc. prior to the announcement of their fourth quarter 2005 earnings.  After the earnings were reported, Whitman allegedly liquidated the position realizing nearly $400,000 in profits.  In another case, Whitman allegedly bought put options on Google Inc. prior to the announcement of their second quarter 2007 earnings.  As a result of the earnings report, Whitman allegedly realized a profit of approximately $600,000.  This action is related to the vast "insider trading ring connected to Raj Rajaratnam and hedge fund advisory firm Galleon Management" involving not less than 30 defendants, securities of more than 15 companies and illicit profits approaching $100 million.

Three Defendants Settle and Additional Defendant Charged in Stock Manipulation Ring, February 10, 2012 (Litigation Release No. 22256)

Earlier this year, the US District Court for the District of Delware entered final judgements against Nathan M. Michaud, Garard J. D'Amaro and Marc J. Riviello concerning a scheme in which the defendants would agree to sell large blocks of penny stocks.  The stocks were allegedly placed in nominee accounts controlled by the defendants.  The defendants then allegedly artificially inflate the market prices and subsequently dumped the shares when a large return was realized.  For more information about the scheme, see the original SEC litigation press release on the matter.   Each of the defendants have been fined and Riviello (Criminal Action No. 09-23-SLR (D. Del.)) and D'Amaro (Criminal Action No. 09-54-SLR (D. Del.)) have served time (for related transgressions).  At the end of 2011, the SEC amended their complaint to include James Meagher as another defendant.

SEC Alleges Brent C. Bankosky Participated in Insider Trading, February 10, 2012 (Litigation Release No. 22255)

The SEC charged Brent C. Bankosky (PDF), a former director of Takeda Pharmaceuticals International, Inc., with insider trading.  The SEC alleged "that Bankosky reaped more than $63,000 of profits, achieving a 169% rate of return, by trading on non-public information about two business transactions in 2008."  Bankosky allegedly traded securities using non-public information concerning Takeda's potential acquisitions and business transactions.  Bankosky has agreed to pay nearly $150,000 to settle the charges.  The US District Court for the Southern District of New Jersey will review the settlement and will "determine whether to impose an officer-and-director bar against Bankosky."

Thursday, February 16, 2012

Should You Cash Out Your Home Equity to Find Your Missed Fortune? -----Careful! A Scam Might Be On the Way

By Paul Meyer, MA and Olivia Wang, PhD

As a result of a lifetime of thrift, many homeowners find themselves in their 50s and 60s with considerable equity in their homes. Some investment advisors and insurance salesmen have been recommending that these homeowners refinance their mortgages to take the equity out of their homes - sometime called “equity harvesting” - to purchase high cost insurance contracts or investments. Whether insurance contracts or high cost investments are being pitched, the advisors and brokers get a big pay day and homeowners end up more highly leveraged and therefore more susceptible to declines in home prices, joblessness and health risks.

For example, in October 2008 an SEC complaint charged five brokers at the World Group Securities Inc. with securities fraud, alleging that the defendants deceived customers into refinancing their homes with subprime mortgages and into purchasing variable universal life (VUL) insurance contracts. The brokers urged their customers to refinance their existing mortgage into subprime adjustable-rate negative amortization mortgages. Such mortgages usually have very low introductory interest rates, but after a period of time sometimes as short as one month, the mortgage interest rate charged increases dramatically. Paul Meyer and Craig McCann filed expert reports and gave depositions on behalf of the SEC.

VULs combine features of whole life insurance with features of mutual fund investments. A substantial portion of investors’ early payments are effectively paid to the sales agent as commissions and are unrecoverable due to high surrender charges in the event the investor needs to withdraw his or her investment.

Depending on the initial premium funding, the contract’s face value, the cumulating cost of insurance (“COI”) and the investment returns it is highly likely the investor will abandon the investment shortly after entering into the contract. Industry experience confirms these fundamental economics. The following figure is Figure 39 from an industry study, reporting the annual lapse rates for various types of insurance policies.




Roughly half the VUL contracts are abandoned within five years and roughly two-thirds of the contracts are abandoned within ten years. Since the cash surrender value is close to zero in early years, VULs, in practice, amount to extraordinarily high cost insurance contracts which expose insurance companies to little mortality risk. VUL purchases reflect poor systematic consumer choices or systematic aggressive sales practice abuses.

Missed Fortune 101” provides a slight twist on aggressive VUL sales. It recommends the purchase of equity-indexed universal life insurance (EIUL) policies instead of VULs with savings that would otherwise be in IRAs or in home equity. The “advice” offered by this program is profoundly bad.

Cashing out home equity to buy high cost insurance or investments dramatically increases homeowners’ debts and all-in costs while systematically reducing their net worth. Only in extremely rare circumstances, especially for older homeowners, would this self-serving “advice” not be part of an abusive sales practice.

Wednesday, February 15, 2012

Home Equity: Changing Perspectives

By Tim Dulaney, PhD

We wanted to write a quick post highlight the changing perspectives of industry experts concerning something as mundane as home equity.  The LA Times reported in August 2005 that, due to the rapid appreciation of real estate values and perceived wealth accumulation, consumers were beginning to spend more freely.  In fact, at the time it was becoming commonplace (and even suggested by experts) to cash out equity in your home to finance otherwise unobtainable, and sometimes transient, purchases (such as a dream wedding).  Paying off your mortgage was seen as a fool's errand.  From the article:
"If you paid your mortgage off, it means you probably did not manage your funds efficiently over the years," said David Lereah, chief economist of the National Association of Realtors and author of "Are You Missing the Real Estate Boom?" "It's as if you had 500,000 dollar bills stuffed in your mattress."
He called it "very unsophisticated."
The LA Times reported in September 2011 that
"High negative equity is holding back refinancing and sales activity and is a major impediment to the housing market recovery," CoreLogic Chief Economist Mark Fleming said in a statement. "The hardest-hit markets have improved over the last year, primarily as a result of foreclosures. But nationally, the level of mortgage debt remains high relative to home prices."
Clearly after the financial crisis and the collapse of home prices, many consumers are looking upon these days of free-spending at the advice of experts with dismay.  It is not hard to gather examples of individuals who cashed out the (temporarily high) equity in their home that now find themselves owing more on their mortgage than their home would fetch on the market.  Those "unsophisticated" individuals who decided not to use their home as an ATM are probably feeling quite sophisticated now with their (un)realized return on the home they currently own.

Hat tip to Eric Falkenstein for bringing this particular news story from our recent past to our attention.

Tuesday, February 14, 2012

In the News: Structured CDs

By Tim Husson, PhD and Olivia Wang, PhD

Bloomberg News reported this week that FINRA is investigating a relatively new type of product that ties the returns of certificates of deposit (CDs) to derivatives. These products are known generally as 'Structured CDs' (SCDs) but also go by 'Index-Linked CDs', 'Equity-Linked CDs' or 'Market-Linked CDs'.  There have also been news stories concerning Market-Linked CDs issued by Wells-Fargo and Equity-Linked CDs issued by Goldman Sachs in recent years.

SCDs have existed since the late 1980s, but have recently become much more popular with conservative investors due to the low yield on traditional deposits and Treasuries. Because SCDs are not securities registered with the SEC, the size of the SCD market is not clear, but estimates range from $20-30 billion and growing according to the July 7, 2011 Bloomberg Structured Notes Brief.

An SCD is essentially an FDIC-insured deposit combined with some combination of options contracts on an underlying asset -- a basket of blue-chip companies or broad indexes such as the S&P 500. The CD part of an SCD serves essentially as principal protection (the return of principal at maturity), and typically bears no coupon. The option part gives the investor some degree of upside market exposure, usually subject to a cap (typically 7-10% annually). The customizability of this structure is similar in many ways to structured products except that structured products are typically issued by banks as debt, rather than insurable deposits.

The demand for safer investments that offer some degree of market exposure has increased as the demand for riskier investments took a hit during the financial crisis, and as returns to traditional fixed-income securities have become less attractive. Market-linked CDs, along with variable and equity indexed annuities, became more popular at this time since these securities combine the market exposure of structured notes with governmental guarantees cherished by risk-averse investors.

Although SCDs offer more robust principal protection than similarly composed structured products, the inherent disadvantages are quite similar.  The Securities and Exchange Commission offers a good introduction -- including a discussion of the risks involved --  to such investments.  They include significant liquidity risk, call risk, and market risk; in fact, structured CDs can be extremely complex investments, and we have seen examples of SCDs linked to term structure strategies, baskets of stocks and commodities, and other highly technical asset combinations, as well as including call features and very long (even 20 year) maturities.

It is not clear for whom these types of complex, illiquid investments would be appropriate.  Indeed, as with structured products, many investors may not understand the importance of the cap in limiting equity exposure, or the significant liquidity risk that comes with the typically multi-year commitment in a SCD.  Also, SCDs are not registered securities and can therefore be sold without a series 7 license, often at high commission levels.

Our research on SCDs is ongoing, and we are developing a broader understanding of the SCD market as well as pricing models that can allow us to quantitatively evaluate the various features of these products.

Sunday, February 12, 2012

An Introduction to Non-Traded REITs

By Tim Husson, PhD and Carmen Taveras, PhD

Both FINRA and the SEC have started warning investors about non-traded real estate investment trusts (REITs), which are growing in popularity but expose investors to very serious risks.  We at SLCG have had a variety of cases involving non-traded REITs and would like to describe our experience analyzing these investments and what they mean for regulators and retail investors.

In the most general sense, REITs are simply companies that hold almost entirely real estate assets.  These companies can obtain special tax treatment if they distribute most of their earnings as dividends.  REITs have been around since the 1960s, but became especially popular in the late 90s and early 2000s.

There are three distinct types of REITs:
  • Traded REITs are listed on a major stock exchange and are subject to all of the disclosure requirements of any other publicly-traded company.  Traded REITs can have very large market capitalizations and have extensive analyst coverage and liquidity.
  • Non-traded REITs are not openly traded on any public market, but are sold through brokers directly to investors.  Non-traded REITs are required to file with the SEC, but have considerable leeway as to how they market their shares to investors.
  • Private REITs are sold only to accredited investors.  They do not file with the SEC, and little is known about the size or extent of the market for these private placement investments.
Non-traded REITs are attracting so much attention because they can be sold to unsophisticated investors who do not understand that they are wildly different than the more ubiquitous traded REITs.

For example, traded REIT shares can be purchased based on their trading price set by the market.  Non-traded REIT shares can typically only be purchased at the initial sale price, regardless of the value of the REIT's real estate portfolio.  This discrepancy between value and price became especially acute in the last few years, when real estate values plummeted but price of most non-traded REIT shares remained exactly the same.  Also, because there is no public market for non-traded REIT shares, they are almost entirely illiquid investments.  Making matters even worse for investors, many non-traded REITs show evidence of paying dividends from new debt, not out of operating income, and have fee structures that pose significant conflicts of interest.

Many of the problems of non-traded REITS were exposed by a FINRA complaint filed against David Lerner & Associates (DLA) in January 2011. FINRA charges included the selling of securities without regard to suitability concerns and the marketing of securities with inaccurate returns data. Apple REIT Ten, the DLA REIT, had maintained a constant price of $11 per share since 2004 and had incurred debt to finance its dividend payments to investors.

Non-traded REITs are an active area of research at SLCG and we will keep posting on related subjects.  There are many informative websites regarding non-traded REITs, including the SEC and IRS websites as well as REITWrecks.com.

Friday, February 10, 2012

Massachusetts Security Regulator Latest to Take Action on BoA CLOs

By Tim Husson, PhD and Olivia Wang, PhD

The Wall Street Journal today reported that Massachusetts is investigating Bank of America for their role in the LCM VII and Bryn Mawr II CLOs.  Secretary of the Commonwealth William Galvin is leading the investigation as to whether the two CLOs priced their underlying assets truthfully at the time of sales to investors.  The subpoenas have also been picked up by BloombergFox Business, and Reuters, amongst others.

SLCG initially reported the mispricing of these CLOs in a research paper earlier this year in connection with the recent FINRA award to Bobby Hayes, who purchased the juniormost tranche of the LCM VII deal.  From that paper:
We provide two examples [LCM VII and Bryn Mawr II] of such problematic CLO offerings in which Banc of America appear to have transferred at least $35 million of losses to investors in July 2007 and which ultimately led to approximately $150 million in losses in just these two CLOs. $35 million of those $150 million in losses occurred before Banc of America sold the securities to investors and only $115 million occurred after investors bought the CLO securities. 
We are excited that the issue of warehoused assets in these products has received attention from regulators and the media, which can play a large role in investor education and awareness.  As we outline in our paper,  we believe that problems with these two products are not unique to CLOs or to Bank of America, and highlight the enormous complexity and opacity of structured credit derivatives.

SEC Litigation Releases: Week in Review


This is the first post in what will become a weekly tradition on the SLCG blog.

SEC Charges Kenneth A. Dachman for Orchestrating a Misappropriation Scheme and Offering Fraud, February 6, 2012 (Litigation Release No. 22254)

The SEC filed a complaint in the U.S. District Court for the Northern District of Illinois alleging that Kenneth A. Dachman had misappropriated nearly $2 million of investors funds by making false and misleading statements concerning the offerings of three companies for which he served as chairman.  In addition, the SEC charged the brokers (Scott A. Wolf and Stone Lion Management, Inc.) because they "acted as unregistered brokers in selling unregistered securities to investors without qualifying for an exemption from the SEC’s registration provisions."  The brokers have agreed to settle (without admitting to the charges filed against them) the dispute by paying approximately $370,000 and by agreeing to be excluded from the offering of penny stock for a period of one year.

Eleventh Circuit Court of Appeals Affirms the Court’s Findings and Remedies Imposed Against W. Anthony Huff,  February 6, 2012 (Litigation Release No. 22253)

In March 2008 (Litigation Release No. 20481), the SEC charged W. Anthony Huff, Danny L. Pixler, Anthony R. Russo, Otha Ray McCartha, and Charles J. Spinelli in the United States District Court for the Southern District of Florida with financial fraud through their involvement with Certified Services, Inc.  The original complaint alleged, over a three year period beginning in 2001, that the defendants "siphoned approximately $30 million from Certified through an elaborate scheme" of inflating the company's financial statements.  The defendants McCartha and Spinelli have consented to the Final Judgments entered by the US District Court providing for full injunctive relief.  Summary of the Final Judgement entered by the Southern District of Florida in this case can be found here: Pixler, Russo and Huff.  This most recent release summarizes the results of the appeals effort taken by W. Anthony Ross.

SEC Charges Smith & Nephew PLC with Foreign Bribery, February 6, 2012 (Litigation Release No. 22252)

The Securities and Exchange Commission today announced a settlement with Smith & Nephew PLC (a London-based global medical device company) to resolve SEC charges that the company violated the Foreign Corrupt Practices Act (FCPA).  In particular, the SEC alleged that the company used a distributor to make illicit payments to public doctors in Greece to increase sales originated from two Smith & Nephew PLC subsidiaries (Smith & Nephew Inc. and Smith & Nephew GmbH) by the doctors. Smith &Nephew PLC agreed (without admitting to the charges filed against them) to settle the SEC’s charges by paying more than $5.4 million and Smith & Nephew Inc. "agreed to pay a $16.8 million fine to settle parallel criminal charges announced by the U.S. Department of Justice today."

Final Judgement Entered Settling Commission's Insider Trading Case Against Attorney,  February 3, 2012 (Litigation Release No. 22251)

In March 2011 (Litigation Release No. 21877), the SEC alleged that the attorney Todd Leslie Treadway profited from trading securities based upon material, non-public information. In connection with the charges filed against the attorney, the United States District Court for the Southern District of New York entered a Final Judgment ordering Treadway to pay almost $40,000.  As a result of the charges, the SEC issued an administrative order "suspending Treadway from appearing or practicing before the Commission as an attorney."

Thursday, February 9, 2012

Could Credit Rating Agencies be Held Accountable This Time?

By Tim Dulaney, PhD and Olivia Wang, PhD

A recent wall street journal article reports that U.S. lawmakers plan to introduce a bill that would require top credit-rating firms to review their credit ratings on a quarterly basis, hoping that more frequent reviews would increase the accuracy of their ratings and help identify potential problems.

­According to Wall Street Journal, the bill would “amend the Securities Exchange Act of 1934 to require the chief executive officer of each [credit-rating firm] to attest, quarterly, to the accuracy of the credit ratings issued by the organization.”

This is certainly not the first time Standard & Poor's Ratings Services, Moody's Investors Service and other rating firms have come under scrutiny for the accuracy of their ratings. Credit rating agencies played a central role in the initiation and the deepening of the 2008 financial crisis. The recent collapse of MF Global Holdings Ltd and the revelation that MF Global was still receiving investment-grade ratings days before it filed for bankruptcy drew renewed attention to the role played by rating agencies in warning investors.

Capital Hill is not the only direction from which such pressures are being exerted. Last year the SEC warned S&P that they were investigating S&P’s practice of giving AAA ratings to mortgage backed securities made up of sub-prime home loans and other collateralized debt obligations right before the 2008 financial crisis. For a detailed report, please see here.

Although such an investigation is long over-due, one cannot be too optimistic about the effectiveness of such regulatory actions. As long as credit rating agencies are paid to rate securities by firms who issue securities, instead of investors who rely upon their ratings to make investment decisions, one cannot expect credit ratings to be an objective description of a security’s credit quality.

True enough, when John Moody invented bond ratings back in 1909, he offered himself as a protector of investors’ interest against irresponsible corporate default. His business prospered in the 1930s together with Moody’s rival S&P when a new set of laws was introduced prohibiting banks, insurance companies, and pension funds to hold bonds unless the debt was investment grade.

A turning point occurred in the 1970’s, when Moody’s started to charge issuer fees. This switch from charging investors to charging issuers made the ratings business increasingly lucrative. According to “The Ratings Charade”, a famous article by Richard Tomlinson and David Evans at Bloomberg Markets which warned the public against the imminent danger of subprime mortgage debt in July 2007, fees collected from structured finance issuances accounted for 44 percent of Moody’s reported revenue of $1.52 billion in 2006. However, this imposes a fundamental challenge to the credibility of the rating firms: how can ratings agencies remain objective if the agencies are paid by issuers to rate their securities?

There is no doubt that both the bill proposed by the U.S. Congress and the investigation conducted by SEC are well-intentioned and would be beneficial to the health of the financial industry; however, as long as the deep-rooted conflict of interest remains, rating firms still have every incentive to deviate from the role they were formed to play: guardians of investors’ interests.

Wednesday, February 8, 2012

ETFs' Asset Value is Increasing, Trading Volume Remains Stable

By Tim Dulaney, PhD and Olivia Wang, PhD

Financial Times reports that the daily trading volume in the 50 most traded US ETFs in this January and last December was at its historical lows, dropping to the level of the end of 2007. This is surprising since over the past decade the total asset value of ETFs have increased from its 2002 level of $102 billion to just over $1 trillion in 2011 according to the Investment Company Institute. Below we plot the ETF total asset value over the last decade.


Intuitively, one would expect as asset value increases, trading volume also increases; however the level of trading activity has remained relatively stable over the past four years. Currently the total ETF trading volume, as measured by the trading activity of the 100 most heavily traded ETFs (excluding those ETFs that were not yet traded at the beginning of 2007), is at approximately the same level as 2007.   Below we plot the trading volume in our sample set of ETFs.

The popularity of ETFs is largely due to low transaction costs and this characteristic was supported by high liquidity in the past. Large institutional investors such as hedge funds usually prop up the trading volume, drive down the trading cost, thus implicitly providing a liquidity subsidy to retail investors. Times of low trading volume could be especially harmful to retail investors since trading becomes more expensive.  Whether the current drop in the trading volume is transient or persistent, we’ll keep a close eye on it.

Tuesday, February 7, 2012

Reserve your Clever ETF Ticker Before it's Too Late

By Tim Dulaney, PhD and Tim Husson, PhD

The Wall Street Journal reported yesterday that descriptive and catchy tickers for Exchange Traded Funds (ETFs) are getting harder and harder to come by these days. From the article:
But finding a catchy symbol can be tough these days. Many have already been taken: 1,350 symbols are in use on the NYSE Arca alone, the biggest U.S. market for exchange-traded products. That's up 108% over the past five years, says Ms. Morrison. In addition, fund firms have reserved 2,446 symbols for future products, with about six new ones being reserved each day, she says. Then there are the tickers of bygone ETFs, whose association with failure means many firms won't use them.
We've certainly run across some memorable ETF tickers in our research and casework, and love the effort issuers put into this no doubt critical aspect of financial marketing. Some of our favorites include:
  • Market Vectors Agribusiness ETF (MOO)
  • Global X Fertilizers/Potash ETF (SOIL)
  • Barclays S&P GSCI Crude Oil Total Return Index ETN (OIL) [though we believe futures based ETFs are no laughing matter]
There has also been a good bit of creativity exhibited in leveraged and inverse leveraged ETF pairs [watch out for daily rebalancing]:
  • Direxion Daily Healthcare 3x Bear (SICK) and 3x Bull (CURE) ETFs 
  • ProShares Ultrashort (KOLD) and Ultra (BOIL) DJ-UBS Natural Gas ETFs
  • iPath S&P 500 VIX Short-Term Futures ETN (VXX) and Inverse S&P 500 VIX Short-Term Futures ETN (XXV) [do be careful with these, too]
We wanted to know: what are some of the best ETF tickers you have come across?

Dealbreaker on the Hayes award and LCM VII CLO

By Tim Husson, PhD, Craig McCann, PhD, CFA, and Olivia Wang, PhD

Matt Levine at Dealbreaker posted last night on our work regarding the Hayes award and the LCM VII CLO. He interpreted some of the facts of the case differently, but we think he did touch upon the key issue: the proper disclosure of the decline in the market price of collateral on the closing date. We wanted to directly address a couple points he raised.

To be clear, at least by the closing date the CLO did track the daily mark-to-market value of the loans in the LCM VII portfolio using Markit’s database of loan values. These figures appear in Trustee Reports that were issued several months after closing—we have made those reports available for download on our website. This indicates that the CLO was aware of the mark-to-market losses on the closing date and was at least capable of determining that value during the warehousing period.

We have also uploaded the marketing materials presented to Mr. Hayes before his purchase, which state that changes in the market value of the E Notes will be a leveraged multiple of changes in the market value of the loans. Since the E Notes were the bottom ½ of 1%, plausible CDO valuation models suggest that leverage to be at least 20 to 1. With the warehoused loans down 5% in July, the market value of the E Notes was close to zero on the day they were sold to the public.

We don’t know exactly how loans were selected for the LCM VII portfolio. But we do know LCM had access to mark-to-market prices and Mr. Hayes didn’t, since as Matt points out he didn’t even know what the underlying loans were, nevermind their value. Big picture: Investors lost $75 million in LCM VII - entirely because of mark-to-market declines in the value of the loans not because of realized defaults on the loans - when it was liquidated in October 2008. Our main point is that $20 million of those $75 million in losses occurred before Banc of America sold the securities to investors, which investors at least deserved to know.