Thursday, February 28, 2013

Evolution of Absolute Return Structured Products

By Tim Dulaney, PhD and Tim Husson, PhD

From 2006 to 2009, a type of structured product known as an absolute return barrier note (ARBN) was issued by a variety of major investment banks.  ARBNs are interesting because they are linked to the absolute value of the return on an underlying, not just its return, and therefore are considered non-directional bets.  We've done a lot of work on ARBNs here at SLCG, including a research paper (PDF) that values a sample of ARBNs and finds they are worth on average 4.5% less than their purchase price on the issue date.

For an example ARBN, see the September 2008 Deutsche Bank Absolute Return Barrier Notes (CUSIP: 25154K635).  The following figure shows a typical ARBN circa 2007.
One of the strangest features of ARBNs is that they seemed to disappear from the market for about 18 months between 2010-2011.  Just before that time, several ARBNs were issued with a modified structure that replaces the principal protection with a buffered downside.  The following figure shows a typical modified ARBN circa 2009.  Again for an example, see the July 2009 Deutsche Bank Absolute Return Barrier Securities (CUSIP: 2515A0M59).

After the hiatus spanning 2010 and early 2011, a new type of ARBN appeared on the market that lacked principal protection and included a capped upside:

An example of such a structure is the April 2011 Deutsche Bank Absolute Return Barrier Securities (CUSIP: 2515A15U1).  This structure is exactly the same as another type of absolute return-based product, dual directionals (DDs).  DDs were issued sparsely starting in 2008, but exploded in popularity in 2012.  Just as we did for ARBNs, we have a paper on DDs (PDF) that value a large sample of products issued up to December 2012 and find that they are worth significantly less than their purchase price on the issue date.

So it seems that after 2009, the principal protection feature of ARBNs became less common and that the ARBN structure slowly evolved into what we see today as dual directionals.  While some dual directionals still use the ARBN brand (especially those issued by Royal Bank of Canada and Credit Suisse), it seems that DDs are an evolution of ARBNs that could be a result of changing market conditions.

Wednesday, February 27, 2013

SEC Issues Letter Regarding Structured Product Valuation Disclosures

By Tim Dulaney, PhD and Tim Husson, PhD

Bloomberg's Kevin Dugan is reporting that the SEC has issued a letter to issuers of structured products late last week that offers guidance for the disclosures of estimated value in offering documents. The SEC letter addresses the concerns we and others have shared over the potential mispricing of structured products, which can be and are sold to retail investors--you can find our research papers on the topic here.

The letter confirms that the SEC will require--though it is not clear exactly when--that structured product issuers disclose their estimation of the fair value of the product as of its pricing date.  Some issuers, such as Goldman Sachs and Bank of America, have already started disclosing fair values on some of their products.  According to Kevin, this letter requires that issuers to exclude most of the commissions and hedging costs associated with the structuring and sale of the notes.  As a result, the issuers will be required to state a value for the product that is derived from the value of its components.

To see an example of how a structured product can be decomposed into several derivatives, such as a fixed-income bond and several options contracts, consider our recent structured product report on the Buffered SuperTrack Notes (PDF) issued by Barclays late last year.  On page 4, we decompose the valuation into its derivative components and value each component separately, then add those values together to value the note itself.  Unfortunately, the issuer valuations we have seen so far only report the bottom-line valuation for the product as a whole, not the value of each embedded derivative.

Nevertheless, these new requirements are a significant step in the development of structured product regulation in the US, and should call attention to the repeated finding in the academic literature that structured products tend to be issued at a premium to fair value.  We will monitor these new valuation disclosures closely to assess their impact on the structured product market and on investors.

SEC Examination Priorities 2013

By Tim Dulaney, PhD and Tim Husson, PhD

Last week, the Securities and Exchange Commission announced their examination priorities (PDF) for 2013 "to communicate with investors and registrants about areas that are perceived by the staff to have heightened risk, and to support the SEC’s mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation."

For those that are unfamiliar, SEC staff conducts examinations of SEC registrants through their regional offices and headquarters
to determine whether the [registrant] is: conducting its activities in accordance with the federal securities laws and rules adopted under these laws (including, where applicable, the rules of self-regulatory organizations subject to the SEC’s oversight); adhering to the disclosures it has made to investors; and implementing supervisory systems and/or compliance policies and procedures that are reasonably designed to ensure that the [registrant] s operations are in compliance with the law.  
Examinations may or may not be announced and the reason for the examination is considered non-public and remains undisclosed.  Examinations are usually completed within 120 days.  If you'd like to read more about the examination process, see here (PDF), and the 2012 priorities can be found here (PDF).

The examination priorities for 2013 reflect a rapidly changing regulatory environment.  For example, the SEC will soon see the first-time registration of thousands of investment advisers as a result of the Dodd Frank Act of 2010 (PDF).  This massive inflow of advisers that "have never been registered, regulated, or examined by the SEC" will force the SEC to prioritize examinations based upon perceived risk.  The SEC also sees the the "convergence in the investment adviser and broker-dealer industry" as a potential breeding ground for conflicts of interest.  Perhaps most interestingly is the SEC's concern over the use of alternative investment strategies--those previously only found in hedge funds, for example--in ETFs and variable annuities.

One of the policy priorities for 2013 is the development of rules implementing the JOBS Act, which includes both crowdfunding and private placement provisions.  The crowdfunding provisions in particular will require the SEC "to conduct reviews of entities participating in the crowd funding business, as appropriate."  As many crowdfunding firms are small online startups rather than established brokerage firms, the SEC's review of these firms could be more complex or challenging. The SEC also "will continue to review the suitability of recommendations of leveraged or inverse ETFs to retail investors."

2013 is shaping up to be a very interesting year for the SEC, as the changing nature of the investment industry is leading to new approaches to regulation and review of registrants.

Friday, February 22, 2013

SEC Litigation Releases: Week in Review

SEC Charges Fund Manager in Scheme Involving Risky Mortgage-Related Investment, February 20, 2013, (Litigation Release No. 22622)

According to the complaint (PDF), George Charles Cody Price "raised $18 million for three investment funds through his firm ABS Manager LLC" promising investors that their investments were "secured by government-backed bonds yielding extraordinary double-digit returns as high as 18 percent per year." In reality, Price was allegedly "investing in one the riskiest tranches of CMOs on the market, and the investments failed to achieve the returns that Price promised."  Additionally, Price purportedly stole "a half-million dollars of fund assets in the form of purported fees." The defendants have been charged with violating various sections of the Exchange Act and Investment Advisors Act. The SEC has named "Price's three investment funds (ABS Fund, LLC [Arizona], ABS Fund, LLC [California], and Capital Access, LLC),..[Price's] company Cavan Private Equity Holdings LLC and his wife's company Lucky Star Events LLC" as relief defendants. The SEC has also "sought a temporary restraining order, asset freeze, receiver, order prohibiting the destruction of documents, and an accounting."

District Court Enters Judgment against New Mexico Ponzi Schemer, February 20, 2013, (Litigation Release No. 22621)

A consent judgment was entered against Douglas F. Vaughan ("a Ponzi schemer who was convicted of fraud in a related criminal case") enjoining him from future violations of securities laws and ordering him to disgorge over $43 million. The disgorgement order was deemed sastisfied "by an order of restitution for the same amount and an order of forfeiture in the criminal prosecution." The original 2010 complaint against Vaughan and his companies (The Vaughan Company, Realtors, Inc. and Vaughan Capital, LLC) alleged that Vaughan used his companies to operate a Ponzi scheme from 1993 to 2010. In 2011, Vaughan pleaded guilty to mail and wire fraud, as well as making false statements to the Commission, and was "sentenced to 12 years in prison, ordered to pay restitution of $43,658,821...and directed to forfeit $74,745,724 to the United States." Judgments have also been entered against Vaughan Realtors and Vaughan Capital that permanently enjoin them from violating sections of the Securities Act and Exchange Act.

SEC Freezes Assets in Swiss-Based Account Used in Suspected Insider Trading Ahead of Heinz Acquisition, February 19, 2013, (Litigation Release No. 22620)

According to the complaint (PDF), suspected insider trading occurred in regards to Berkshire Hathaway's and 3G Capital Partners. Ltd.'s acquisition of Heinz. According to the SEC, a group of "unknown traders took risky bets that Heinz’s stock price would increase" the day before the public announcement. Suspiciously, the account "through which the traders purchased the options had no history of trading Heinz securities in the last six months." The SEC obtained an emergency court order that "freezes the traders’ assets and prohibits them from destroying any evidence." The SEC seeks permanent enjoinment and payment of disgorgement and financial penalties.

District Court Grants Securities and Exchange Commission's Motions for Default Judgment against a Nationally Known Psychic and his Corporate Entities in Multi-Million Dollar Offering Fraud, February 15, 2013, (Litigation Release No. 22619)

Default judgments were entered against Sean David Morton,  "a nationally-recognized psychic who bills himself as "America's Prophet, his wife, relief defendant Melissa Morton, and corporate shell entities co-owned by the Mortons." The SEC's 2010 civil injunction action against Morton charged him with fraudulently raising over "$5 million from more than 100 investors for his investment group, which he called the Delphi Associates Investment Group." Morton allegedly made false claims that "he has called all the highs and lows of the stock market, on their exact dates, over a fourteen year period...[and] falsely asserted that the alleged profits in the accounts were audited and certified by PricewaterhouseCoopers LLP." Additionally, Morton allegedly lied about his "past successes and about key aspects of the Delphi Investment Group, including the use of investor funds and the liquidity of the funds." The default judgment orders the defendants to pay, jointly and severally, over $11 million in disgorgement, prejudgment interest and penalties. Relief defendants Melissa Morton and the Prophecy Research Institute, were ordered to pay almost $575,000 in disgorgement and prejudgment interest. The judgment also permanently enjoins the defendants from future violations of the securities laws.

District Court Grants Securities and Exchange Commission's Motions for Default Judgment against a Nationally Known Psychic and his Corporate Entities in Multi-Million Dollar Offering Fraud, February 15, 2013, (Litigation Release No. 22618)

Last week, Delsa U. Thomas, The D. Christopher Capital Group, LLC, and the Solomon Fund LP were charged with "defrauding investors out of $2.3 million in a high-yield investment scheme." According to the SEC, Thomas falsely promised that "$1 million in investor funds would remain safely invested in U.S. Treasury securities and would yield 650 percent returns in 35 banking days." In addition, Thomas purportedly used investor funds to make Ponzi payments. The complaint also alleges that "DCCMG was improperly registered with the Commission as an investment adviser." The SEC has charged the defendants with violating sections of the Securities Act and Exchange Act and seeks "permanent injunctions, disgorgement of ill-gotten gains plus prejudgment interest and civil penalties against each of the defendants."

Thursday, February 21, 2013

How Big of an Effect Does Securities Lending Have on ETF Returns?

By Tim Dulaney, PhD and Tim Husson, PhD

We earlier posted an analysis that compared ETF returns to their stated index net of fees for funds that lend securities and those that do not. IndexUniverse subsequently suggested an approach with methodological differences from our original work and we wanted to address some of those differences here.

For our sample, we used Bloomberg's ETF function to collect all US-domiciled, USD-denominated exchange-traded funds and removed any with active trading strategies, leverage, or inception dates after January 1, 2010.  We then restricted ourselves to funds that hold only US equities, independent of market capitalization.  We used daily data from between February 16, 2012 and February 15, 2013 for our analysis.

We then checked whether the underlying index for each ETF as reported by Bloomberg was a total return or a price return index.  Based on IndexUniverse's calculation methodology, we compared the fund's total return (based on NAV) to the return of the index minus the fund's expense ratio for funds that track a total return index.  For funds that track a price return index, we compared the fund's NAV return to that of the underlying index, again minus the expense ratio.  We then aggregated these results for ETFs that participate in securities lending programs and those that do not, as reported by Bloomberg.

The resulting distributions are shown below:
The resulting averages are minuscule--just a few basis points on returns that vary on the order of tens of percentage points. While there is a small difference in average, median, and asset-weighted average between the two groups of funds, the standard deviation of these distributions is far larger than those differences.  A simple difference of means test shows that funds which lend securities do not outperform their index net of fees by a significant amount when compared to funds which do not lend securities.

We calculated the same metrics as above based on market price total returns instead of NAV returns, which resulted in the following distributions:

While the average values for each distribution rose slightly using price rather than NAV total return measures,  they are again extremely small.  In both the lending and non-lending distributions the standard deviation is much larger than the difference in means, suggesting that the effect of securities lending is likely small.  It appears that firms that participate in securities lending programs appear to have a lower standard deviation and more clustering around 0%, suggesting that securities lending may enable funds to more precisely track their underlying index.  However, given the variation in these data sets, it is difficult to statistically distinguish the two distributions.

This is in contrast to IndexUniverse's finding that "after accounting for expense ratios, ETFs that lend portfolio securities did a demonstrably better job tracking their index."  We find no significant difference between the two distributions over the past year.  The sample we use here is different IndexUniverse's but we both find a minute effect that is, in the end, likely attributable to noise.

Wednesday, February 20, 2013

Securities Lending by ETFs

By Tim Husson, PhD and Tim Dulaney, PhD

One of the most contentious but least understood aspects of the stock market is short selling.  Short selling refers to selling a stock that you do not own at current market prices, with the hopes that the stock will go down in price.  The stock can be purchased in the market at any time to close out the position and, if the stock has decreased in price, the short-seller will realize a profit.  Obviously, the only way to accomplish this is by borrowing that stock from someone else.

Typically, portfolio managers that have very large stock or mutual fund positions (say, for a pension fund) may loan those securities out to short sellers.  When they do so, they charge an interest rate to the short seller, and thus earn an extra source of revenue.  The rates charged are typically small, but for stocks that are very hard to borrow, that rate can be larger.  These loans are relatively low risk since they are required to be fully collateralized above the mark-to-market value daily (typically at least 102% and perhaps higher depending upon the security).  However, if this collateral is invested in unsafe investments, than as pointed out by Jason Zweig in 2009, investors could unknowingly be financing risky bets by the managing company.

As ETFs have become a larger and larger market force, some ETF issuers have begun lending their shares and thus earning this revenue.  In fact, this is one way in which a passive ETF can outperform its benchmark index net of fees.  While ETFs registered as unit investment trusts (such as SPY) are not allowed to lend its shares in this fashion, others seem to be taking advantage.  As reported by Jason Kephart of InvestmentNews, securities lending proceeds can have a significant impact on ETF returns:
Securities lending plays a big role in the performance of ETFs. In a logical world, ETF investors should expect to get the returns of an index minus the expense ratio.
Earnings from securities lending allow many larger ETFs to outperform their expense ratio, though, according to Mike Rawson, ETF analyst at Morningstar Inc. 
However, a lawsuit was filed recently (PDF of the complaint here) by two trade unions who argue that iShares, the largest issuer of ETFs in the US, kept too much of that income for itself--up to 40%--instead of passing it along to investors.  Dave Nadig at IndexUniverse argues that while there may be a conflict of interest between ETF issuers lending to short sellers, iShares did nothing out of the ordinary to cause harm to its investors.

We took a look at the ETFs involved in the iShares suit and compared their total returns over the year ending February 15, 2013 to the returns of their underlying index over the same period:

We find that over this period, some funds (IWF, IWO, IWN, IJH and IJR) were indeed able to outperform their respective indexes net of fees.  However, the other funds underperformed, sometimes by even more than their operating expenses.  This suggests that securities lending revenue may not be the most significant cause of tracking error, and may not make up for other sources of deviation between a fund's returns and that of its index.

An interesting sidenote from iShares' IJR prospectus is that "[i]f your Fund shares are loaned out pursuant to a securities lending arrangement, you may lose the ability to treat Fund dividends paid while the shares are held by the borrower as qualified dividend income."  This may be a way in which securities lending could affect ETF investors without investors' prior knowledge.

It's not clear how much of securities lending proceeds should be passed on to investors--perhaps this lawsuit will help speed that discussion.  At the very least, more comprehensive disclosures related to securities lending could help investors (and analysts) better understand what's 'under the hood' of ETF returns.

Tuesday, February 19, 2013

Chinese Markets are Closed--So What Happens to China-based ETFs in the US?

By Tim Dulaney, PhD and Tim Husson, PhD

Happy Chinese New Year!  Markets were closed in many Asian countries last week, while US markets remained open.  As noted by several commentators, this means that while US ETFs that hold Chinese equities were actively traded, their underlying assets were not.  So what does this mean for China-based ETFs traded in the US?

First, it's important to note how ETFs relate to their underlying assets.  Essentially, ETF shares can be created by certain traders (called authorized participants) by buying the underlying assets of the ETF (in this case, shares of Chinese stocks) and delivering them to the ETF issuer.  This process allows the price of the ETF to stay 'in line' with the price of the underlying assets.

However, if the authorized participants cannot buy the underlying stocks, this price discovery mechanism cannot take place.  This is actually not a rare occurrence when it comes to Asian or Australian ETFs:  because these markets are open when US markets are closed overnight and vice versa, this actually happens every day.  What happens is that active participants make guesses as to the value of the underlying securities.  From iShares:
Now, this may seem like a hassle for the authorized participants, but the truth is there are many ways for them to make educated guesses about where these securities should trade when their exchanges are closed. One popular method is to use the percent change of the US market (for example, via the S&P 500) and assume that other countries will have a similar move, while also incorporating the continuously traded foreign exchange market to account for currency movements.
There are two ways to look at this issue:  either the US ETF market is providing price discovery to assets whose native markets are closed, or the US ETF market is deviating from the value of the underlying assets during the trading day.  While this is to some degree a matter of perspective, we decided to look at the largest ETF holding only Chinese equities (FXI) and compare it to the largest holder of US equities (SPY).  Specifically, we wanted to see whether overnight moves were larger for FXI or for SPY on average.  If so, that would suggest that price discovery was happening overnight (when Chinese markets are open) rather than during the US trading day.

We found that between 2005 and 2013 the mean absolute overnight return was much larger than the mean absolute intraday return for FXI.  The opposite is true for SPY.  This suggests that larger moves happen overnight for FXI and intraday for SPY.  We also tested the median absolute return, the standard deviation of absolute returns and the standard deviation of returns which all showed the same pattern.  

It's important to understand how ETFs work and how their returns relate to the value of the underlying assets.  In this particular case, it seems that although FXI trades on a US exchange the majority of the price discovery may occur overnight rather than intraday like most US equities.

Friday, February 15, 2013

Structured CDs: The Big Picture

By Tim Dulaney, PhD and Tim Husson, PhD

This week we have reviewed some of the issues surrounding structured certificates of deposit, giving an introduction, example offering documents (both simple and complex), the basics of FDIC insurance of these products, and a description of some of the tax implications investors should be aware of.  We hope we have conveyed our reasons for thinking that structured CDs are complex and risky investments that, like structured products, are rarely suitable for retail investors.

But there is a bigger picture to consider as well.  We've described structured CDs that are similar to principal protected notes (equity-linked CDs) and interest rate linked structured products (range accruals).  Some structured CDs, such as this example from Union Bank, have equity exposure subject to quarterly caps and a minimum return, similar to equity-indexed annuities.  It is no coincidence that these very different products offer the same basic types of payoffs.  Banks have determined what types of exposure they can profitably offer investors, and can offer it any of several different packages.

Importantly, each type of product has very different regulatory treatment, even if it offers the same or similar exposure as another class of investment.  Structured products, being debt securities, are registered with the SEC and subject to its regulatory oversight.  Indexed and fixed annuities, being insurance products, are subject to more state-level regulation.  Structured CDs, as bank deposits, are under the FDIC's jurisdiction.  Each of these regulatory frameworks has different disclosure requirements, limitations, and investor protections, but in each of these cases, the issuer takes a position that it can profitably hedge--that is, a position that it can purchase cheaper in derivatives markets.

So while low interest rates may have made traditional CDs and other 'vanilla' investments seem unsatisfying, we would caution investors from aiming at higher returns via structured CDs.  The underlying risks, including the information asymmetry that exists between banks and retail investors, can mean investors may be getting less in expected value than they put in.

Tax Consequences of Market-Linked CD Investing


On this last day of structured CDs week here on the SLCG blog, we're going to discuss the tax consequences of investing in market-linked CDs (or structured CDs). We should probably start a blog post on taxes with a general disclaimer that we are not tax professionals and you should consult a tax professional or CPA before making an investment decision based upon tax consequences.

That being said, taxes are a pretty complicated issue for structured CDs. As mentioned earlier this week, realization and accrual of interest is not simultaneous with structured CDs.   Most structured CDs that we've seen do not credit the investor with interest that is contingent upon market movements until, in the best case, the next interest accrual date or, in the worst case, until maturity.  For example, this JP Morgan market-linked CD (PDF) does not accrue interest until maturity while this JP Morgan market-linked CD (PDF) accrues interest on a quarterly basis.

For tax purposes, however, investors in these notes are usually "required to recognize interest income in each year at the 'comparable yield'" according to JP Morgan structured CD disclosures (see the examples above).   This is usually based upon a fixed rate and the payment the issuer expects to make at maturity.  This determines the Original Issuer Discount or (OID).  On the other hand, it is possible that no payment will be due at all when the product matures depending on market conditions during the term of the CD.

This results in a phenomenon known as "phantom income".  From the FDIC:
One of the key components of a market-linked CD is that, unlike most fixed-rate CDs, interest earned might only be accrued (unconditionally added to the account balance) when the CD matures. However, you may be required to include interest income in your taxable income each year that you receive a Form 1099-INT from the issuing bank, even though you were not paid interest during that year but will be paid the interest at the maturity of the CD. Paying tax on interest earned but not paid to you is commonly known as “phantom income.”  A tax advisor or CPA can explain the tax implications of “phantom income.”
Another idiosyncrasy with market-linked CDs is that, although these are long-term investments (sometimes fifteen years or more) and dependent upon the performance of some market index, the appreciation in value is not taxed as long-term capital gains but as ordinary income (which historically has been subject to a much higher rate).  Some of these complications might be avoided by holding structured CDs in a tax-deferred account such as an Individual Retirement Account (IRA), but in general, the market-linked component of structured CDs could be less optimal from a tax point of view than other forms of market-linked income.

SEC Litigation Releases: Week in Review

Court Enters Final Judgments Against Former Wall Street Banker, Downstream Russian Trader and Trader’s Wife in Insider Trading Scheme, February 13, 2013, (Litigation Release No. 22617)

A final judgment has been entered against Alexander Vorobiev and his wife, "relief defendant Tatiana Vorobieva," for their involvement in an insider trading scheme that resulted in over $1 million in illegal profits. Vorobiev traded using insider information regarding "numerous health care-related acquisitions, tender offers, and other transactions" involving UBS's Global Healthcare Group. He allegedly gained the information from Igor Poteroba, an investment banker with UBS Securities LLC. The final judgment permanently enjoins Vorobiev from future violations of the securities laws and orders him to pay over $2 million in disgorgement, prejudgment interest, and civil penalties. Vorobieva has been ordered to pay over $550,000 in disgorgement, prejudgment interest, and civil penalties.

SEC Obtains Judgment Against Investment Adviser in Connection with Cherry-Picking Scheme, February 12, 2013, (Litigation Release No. 22616)

A final judgment was entered against Howard B. Berger, whom the SEC charged with securities fraud and investment adviser fraud last September. Berger was the "founder and manager of Professional Traders Management, LLC and Professional Offshore Traders Management, LLC, which managed and acted as investment advisers for hedge funds Professional Traders Fund, LLC (“PTF”) and Professional Offshore Opportunity Fund (“POOF”)." According to the SEC's charges, Berger "cherry picked profitable trades from PTF...and allocated the trades to his wife’s brokerage account" as well as "allocated unprofitable trades to PTF and POOF." The final judgment permanently enjoins Berger from violating the securities laws and orders Berger along with relief defendant, wife Michelle Berger, to pay over $6.9 million jointly and severally in disgorgement, prejudgment interest, and civil penalties. Additionally, Berger has been barred from  associating with "any broker, dealer, investment adviser, municipal securities dealer, or transfer agent."

SEC Halts $150 Million Investment Scheme to Dupe Foreign Investors and Exploit Immigration Program, February 8, 2013, (Litigation Release No. 22615)

According to the complaint (opens to PDF), Anshoo R. Sethi "created A Chicago Convention Center  and Intercontinental Regional Center Trust of Chicago and fraudulently sold more than $145 million in securities," collecting $11 million in administrative fees from Chinese investors. Sethi allegedly told investors their investments would finance the "construction of the 'World’s First Zero Carbon Emission Platinum LEED certified' hotel and conference center near Chicago’s O’Hare Airport." He then purportedly misled investors to "believe their investments were simultaneously enhancing their prospects for U.S. citizenship through the EB-5 Immigrant Investor Pilot Program." Sethi claimed to have Hyatt, Intercontinental Hotel Group, and Starwood Hotels' participation in the project, but in reality " none of these hotel chains have executed franchise agreements to include a brand hotel in [the] project." Additionally, Sethi allegedly spent over 90 percent of the administrative fees, despite his promise to return them to investors "if their visa applications are denied." The SEC obtained an asset freeze against Sethi and his companies, and "seeks permanent injunctions and other monetary relief."

Former IndyMac CFO Dismissed from SEC Litigation, February 7, 2013, (Litigation Release No. 22614)

A motion for summary judgment was granted for A. Scott Keys, former chief financial officer of IndyMac Bancorp, Inc. The court issued a final judgment in his favor. The original complaint against Keys charged him with failing "to disclose IndyMac Bank’s deteriorating capital and liquidity positions in IndyMac’s offering materials for the sale of new stock to investors prior to [his] departure from IndyMac in April 2008."

Thursday, February 14, 2013

So How Complicated Can Structured CDs Get?


We could tell you that the last time we went fishing we caught a fish that was THIS BIG (motions with outstretched arms), but you probably wouldn't believe us unless we showed you.  We wanted to take this opportunity to show some examples of truly complex structured certificates of deposit that have been constructed in recent months and years.

Let's take a look at JP Morgan's August 2012 fifteen year "Callable Variable Rate Range Accrual CDs Linked to 6-Month USD LIBOR and the S&P 500 Index" -- disclosure can be found here (PDF) and the deposit was given the CUSIP 48124JHT8.  This CD
  • pays interest quarterly based upon the number of days the S&P 500 exceeds a certain level (80% of the pricing date level), an interest factor and a leverage factor;
  • has an interest factor that changes throughout the term of the deposit and, after the first year, that depends upon the difference between a fixed rate and six month LIBOR;
  • has a minimum interest rate of 0% and a maximum interest rate that changes during the term;
  • can be called on a quarterly basis at JP Morgan's discretion at face value (plus any accrued and unpaid interest).
Let's look at how complicated it can be to determine the interest owed during a given period.  Consider the interest period from August 31, 2013 to November 30, 2013.  Assume that the S&P 500 was above 1,127.44 (80% of S&P 500 level on August 28, 2012) for 80 days during the quarter which consists of 90 days.   Assume that 6 month LIBOR was 4.5% as of August 29, 2013 (the interest reset date).

The interest rate that would be credited for this quarter on November 30, 2013 is the leverage factor (1.1) times the difference of (5.5% and 6 month LIBOR, 4.5%), so long as it is less than the maximum rate (6.05%) for this period. So this part would yield 1.1*(5.5%-4.5%) = 1.1%. This is larger than the minimum rate of 0% and so we would just multiply this rate by the fraction of days the "accrual provision" is satisfied (80/90), yielding 0.977777%. This would then be rounded according to the rounding formula used by the calculation agent to yield 0.978% per annum (day-count convention ACT/365). Of course all this assumes that the CD has not been called by that point (first call date is August 31, 2013).

Each of these features are very difficult for retail investors to value.  Range accruals are not simply directional bets reflecting a bullish or bearish outlook on a particular asset or index, they are complex bets on the relationship between different assets and the statistical likelihood of breaching specific barrier levels.  In addition, the embedded call provision grants JP Morgan the ability to redeem at par if market conditions change in the investor's favor.

According to Bloomberg, four million dollars worth of this CD were issued in August 2012 and the CDs paid interest on November 31, 2012 at a rate of 7.25% per annum.  If any of these investors bought an amount that exceeds the current FDIC insurance limit, the principal amount beyond that limit will not be FDIC insured.  Interest is not accrued until interest payment dates when the interest payment is calculated (see above) and as a result would not be covered by FDIC insurance should the bank go under.

So how complicated can structured CDs get?  Really, really complicated.  

Wednesday, February 13, 2013

FDIC Insurance and Structured CDs


As a continuation of our structured CDs week here on the SLCG blog, today we're going to discuss one of the biggest selling points for these products: FDIC insurance. FDIC insurance mitigates most of the credit risk found in structured products, but it may not be as significant a factor as the marking materials for structured CDs may suggest.

Structured products, the debt analog of structured CDs, are often maligned because of their exposure to credit risk. If the issuer of a structured product is unable to pay their obligations as they become due, investors could realize substantial losses. This is precisely what happened when Lehman Brothers went bankrupt, as Lehman was at the time one of the largest issuers of structured products -- see our paper on the subject (PDF).

FDIC insured deposits, on the other hand, are backed by the full faith and credit of the US government if the issuing bank goes under. There are of course limits to the amount covered by FDIC insurance. The Emergency Economic Stabilization Act of 2008 (PDF) temporarily increased the maximum deposit insurance amount from $100,000, established in 1980, to $250,000 per account (see 136(a)(1)) and the Helping Families Save Their Homes Act of 2009 (PDF) extended this increase through December 31, 2013 (see 204(1)(1)(A)).  This new limit was made permanent by the Dodd Frank Act of 2010 (PDF).

One thing investors should appreciate is that FDIC insurance covers only the principal repayment at maturity, not interest payments (unless the interest payments are guaranteed).  In a structured CD, that means any market-linked payments, which are the interest generating part of the investment, are not insured and are therefore exposed to the issuer's credit risk. According to the FDIC warning issued in spring 2012:
If the bank has guaranteed that the principal will not go down in value, the FDIC will cover both the principal and any accrued interest, up to the federal insurance limit. But if interest is only credited at maturity [as in structured CDs], and if the bank were to fail before the CD matured, no interest would be insured because no interest had accrued.
For example, yesterday we covered an HSBC structured CD issued in May 2012 that has payment at maturity with a guaranteed minimum component and a contingent component.  Should HSBC default prior to maturity, the FDIC would cover the principal investment, but no interest contingent upon market performance since this is not due to the investor until maturity.

The implication of FDIC insurance is that a structured CD will be slightly more valuable than an exactly equivalent principal protected note on the same underlying issued on the same day. However, it is unlikely that such an exact pair would exist in the market. In our experience, structured CDs are typically longer term (have a longer time to maturity) than similar principal protected notes, which decreases their value to investors.

The realization and accrual of interest is another complication of structured CDs. The FDIC warns that although some structured CDs -- see, for example, the following JPM market-linked CD (PDF) -- do not credit interest during the CD's term, you may be required to recognize interest income for tax purposes at a "comparable yield" for the product. This results in a phenomenon commonly known as "phantom income" and we'll have another post later in the week discussing the tax consequences of market-linked CD investing.

So while FDIC insurance does partially address one important criticism of structured products (namely, credit risk), it does not completely protect investors from issuer default.  The value of FDIC insurance can be mitigated by the issuer adjusting other product parameters (more volatile market indexes, longer term, etc.), and leads to other complications of which investors should be fully aware.

Tuesday, February 12, 2013

What Does a Simple Structured CD Look Like?

By Tim Dulaney, PhD and Tim Husson, PhD

Okay, we've talked a bit about what structured CDs are and why we think they are interesting.  But what does a structured CD offering document actually look like?  Unfortunately, it isn't possible to find such documents from Bloomberg or the SEC website since structured CDs are not registered securities.  However, you can often find offering documents using Google.  For example, as a relatively simple equity-linked CD, we're going to take a look at the "Global Opportunity Certificate of Deposit with Minimum Return" which was issued by HSBC in May 2012 with the CUSIP 40431GS75 (PDF).

This product is linked to not one but several securities, referred to as the underlying 'basket,' which includes in equal parts the Dow Jones Industrial Average, the Dow Jones EURO STOXX 50 Index, and the TWSE (Taiwan Stock Exchange) Index.  Basket products are common among both structured CDs and structured products, and are one way issuers can add complexity/diversification to the product.  The final payout at maturity is subject to a minimum return of 0.75% corresponding to an annual percentage yield of 0.10% for the seven year product.

The payoff for this type of product is shown below, and is very similar to structured products known as principal-protected notes:


This payout diagram also resembles that of a long call option, except with the return of original principal paid.  Therefore, this product can be modeled as the combination of:
  1. A zero-coupon bond with a single payment at maturity of the initial investment amount plus 0.75%, and
  2. A call option on the underlying basket with a strike price that is in-the-money by 0.75%.
The bond component's value will be less than the payout at maturity due to the time value of money.  However, unlike structured products, this component is FDIC insured such that it is not subject to the credit risk of the issuer (we'll discuss the implications of FDIC insurance in tomorrow's post).

The call option for this simple product is somewhat complex -- referred to as an "average price option" or "Asian option".  The payoff of this particular structured CD depends on the quarterly average portfolio level during the term of the CD.  If the average portfolio level (determined by the 28 quarterly observation dates) is higher than the initial index level, the CDs may return more than the minimum 0.75%.  The FDIC views the interest payment uncalculable prior to maturity and as a result the payment would not be covered should the bank go under.

The call option will have a positive value that is dependent on several factors including the volatility of the underlying indexes.  The question is: is the value of the call option greater than the value of the bond discount?

One important variable in determining that value is the very long term of this product (seven years).  The long term erodes the value of the components dramatically.  Also, the fact that you cannot buy and sell these products in the open market suggests that their true value may be even less, a phenomenon referred to as an  illiquidity discount.

These factors would be difficult for most retail investors to appreciate, let alone precisely value.  Banks, however, have sophisticated models that can value these components quickly and easily.  It should be clear that structured CDs are nowhere near as simple and assured an investment as traditional CDs, just as structured products are nowhere near as simple and assured as corporate debt.

Monday, February 11, 2013

Structured Certificates of Deposit Week


Over the past several months, we have noticed more and more bank deposits that resemble structured products.  These products go by various names: market-linked certificates of deposit, equity-linked certificates of deposit, contingent interest certificates of deposits, etc.  For parsimony, we refer to these types of products as "structured CDs" or simply "SCDs".

We think structured CDs are a very significant development, as they can be designed to provide highly complex exposure, are almost entirely illiquid, and are sold in a non-transparent marketplace.  We have discussed structured CDs briefly in the past, but we think that the structured CD market is so interesting, and coverage of the subject in the financial media is so sparse, that we are devoting this week to explaining what these products are, how they work, and why we think they are worth paying attention to.

Structured CDs are basically bank deposits that resemble principal protected structured products.  Like traditional CDs, they promise return of principal at maturity along with interest payments, except that the interest component of a structured CD depends on the value of reference assets such as stocks, ETFs, interest rates, or indexes.  This derivative component can be made extremely complex, or the SCD could be linked to an asset that itself has complex exposure.

On major selling point for structured CDs is that they are eligible for FDIC insurance since technically they are a type of bank deposit.  While structured products, which are technically debt, expose investors to the credit risk of the issuer, some portion of a structured CD is backed by the full faith and credit of the US government should the bank go under.  We'll go into the details of FDIC insurance in a post later in the week.

Structured CDs are also almost entirely illiquid.  Like traditional CDs, redemption before maturity typically incurs a penalty or fee, and interest is typically non-transferable.  Because of the limits of FDIC insurance, structured CDs are typically sold in small units, suggesting they are marketed primarily to retail investors.  Despite the clear resemblances to derivatives and other complex securities, structured CDs fall outside of the purview of the SEC and its disclosure requirements.  As a result, the full extent of the structured CDs market is difficult to ascertain (though it has been estimated at approximately $25 billion annually), as are the sales practices through which they are sold to investors.

We hope you stay tuned and contribute to the discussion, either through the comments section or by emailing us any questions or suggestions you may have.  Welcome to structured CDs week at the SLCG Blog!

Friday, February 8, 2013

Mis-sold Interest Rate Hedges

By Tim Dulaney, PhD and Tim Husson, PhD

The Financial Services Authority (FSA), Britain's highest financial regulatory agency, has ordered Barclays, HSBC, Lloyds, and Royal Bank of Scotland to review all of their interest rate linked swap agreements sold to small businesses.  In an investigation, the FSA found (pdf) that four banks had violated at least one of its rules in over 90% of the 173 cases reviewed.  The London Evening Standard is reporting that seven other banks may also launch similar reviews.

Interest rate swaps -- and related interest rate derivatives -- are derivative instruments that are often used to hedge certain liabilities.  For example, a small business might use an interest rate swap to convert a floating-rate liability, such as an adjustable rate loan, to a fixed-rate liability.

Interest rate swaps are also widely sold throughout the world, including the United States, to businesses, municipalities, and other institutions.  In fact, the current major US class actions related to the LIBOR interest rate fixing scandal are led by investors, such as the City of Baltimore, who purchased interest rate swaps -- you can find the Baltimore complaint here (pdf).  For more information on interest rate swaps, see our review here.

From the FSA report:
We have evidence which raises concerns about the sales we have reviewed in certain banks. These concerns include (i) inappropriate sales of more complex varieties of interest rate hedging products (such as structured collars) and (ii) a number of poor sales practices used in selling other interest rate hedging products. We also found that sales rewards and incentive schemes could have exacerbated the risk of poor sales practice. Practices varied across banks, but we found sufficient evidence of poor practices to justify action by the FSA.
Interest rate derivatives can be extremely complex investments.  Although these instruments are often sold as purported hedges to "cut costs" or "decrease liabilities", their complicated structure obfuscates risk and can allow banks to embed fees.  We have found that even changing a parameter as seemingly insignificant as the day count convention can lead to substantial shifts in value.

Small businesses and municipal investors should be particularly careful when considering these types of derivatives.  The FSA found that in their sample, sales of interest rate hedging products to "non-sophisticated" investors often include:
  • poor disclosure of exit costs;
  • failure to ascertain the customers' understanding of risk;
  • non-advised sales straying into advice;
  • "over-hedging", i.e. where the amounts and/or duration do not match the underlying loans; and
  • rewards and incentives being a driver for these practices.
We have seen numerous examples of each of these poor sales practices -- sometimes even within the same case.  Finding a disinterested party, or an "independent reviewer", to analyze a prospective interest rate hedging product is of paramount importance.   Small and medium sized businesses need to be vigilant advocates for their own interests in these transactions, both before and after an agreement has been made.

SEC Litigation Releases: Week in Review

Steven Harrold Settles SEC Insider Trading Charges, February 6, 2013, (Litigation Release No. 22613)

A final judgment was entered against Steven Harrold, former executive at a Coca-Cola bottling company, for his alleged insider trading "based on confidential information he learned on the job" concerning Coca-Cola Enterprises Inc.'s planned acquisition of The Coca-Cola Company's " bottling operations in Norway and Sweden." The judgment permanently enjoins Harrold from future violations of various sections of the Exchange Act and orders him to pay over $180,000 in disgorgement, prejudgment interest, and civil penalties. In addition, an officer and director bar has been placed against Harrold.

SEC v. James Balchan, February 6, 2013, (Litigation Release No. 22612)

According to the complaint (opens to PDF), James Balchan traded with inside information ahead of Texas Instrument's acquisition of National Semiconductor Corporation, gaining almost $30,000 in illegal profits. Balchan allegedly "gleaned [the information] from his wife, a partner at a large law firm that was consulted on the deal." Balchan has agreed to pay over $60,000 in disgorgement, prejudgment interest, and penalties to settle the charges.

SEC Obtains Judgments Against Former Officers of Gibraltar Asset Management Group LLC, February 5, 2013, (Litigation Release No. 22611)

Final judgments were entered against four defendants for their alleged involvement in "a multi-million dollar Washington-area Ponzi scheme operated through Gibraltar Asset Management Group, LLC and Garfield Taylor, Inc." Benjamin C. Dalley, former Vice President of Operations at Gilbratar, Randolph M. Taylor, former Vice President for Organizational Development at Gibraltar, William B. Mitchell, former Vice President for Finance at GTI and Executive Vice President of Strategic Planning at Gibraltar, and relief defendant, Reverb Enterprises LLC, have been ordered to pay over $320,000 total in disgorgement, prejudgment interest, and penalties. Dalley, Taylor, and Mitchell have also been permanently enjoined from violating various sections of the securities laws. In addition, Mitchell has been barred from associating with "any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization" and has also been barred from "from participating in any offering of a penny stock." The SEC's case is still pending against: Garfield M. Taylor, Jeffrey A. King, Maurice G. Taylor, GTI, Gibraltar, and The King Group, LLC.

SEC v. Patrick M. Carroll, James P. Carroll, William T. Carroll, David Mark Calcutt, Christopher Calcutt, David Stitt, John Monroe and Stephen Somers, February 5, 2013, (Litigation Release No. 22610)

Four executives from Steel Technologies, Inc. and two of their tippees have agreed to pay over $630,000 to settle SEC charges of insider trading. According to the SEC's 2011 complaint, Patrick M. Carroll, James P. Carroll, William T. Carroll, David Mark Calcutt, Christopher T. Calcutt, and David Stitt all engaged in insider trading in connection with Mitsui & Co.'s acquisition of Steel Technologies, Inc. The SEC's charges against John Monroe and Stephen Somers still remain pending.

Former Investment Adviser Sentenced to 12 Years for Misappropriating Client Assets, February 5, 2013, (Litigation Release No. 22609)

Charges were entered against Timothy J. Roth, a former investment adviser at Comprehensive Capital Mangement, Inc., sentencing him to 151 months in prison as well as ordering him to pay over $16 million in restitution to his victims. The criminal judgment stems from a 2011 SEC charge that Roth misappropriated "over $16 million worth of mutual funds from the accounts of eleven clients between 2004 and 2011."

SEC Charges We The People, Inc., of The United States and Three Individuals In Offering Fraud Scheme, February 4, 2013, (Litigation Release No. 22608)

The SEC has filed complaints against We The People, Inc. and Richard and Susan Olive, former chief of program services and former chief of finance and adminstration, respectively. The SEC alleges that the Olives preyed on senior citizens across the U.S, orchestrating a "fraudulent scheme that raised more than $75 million" through We The People, Inc. We The People and the Olives allegedly "lured investors by making various false and misleading statements regarding, among other things, the value of the products sold and the safety and security of the investments." In addition, the Olives failed to disclose to investors "indictments and regulatory sanctions issued against them for fraudulently selling similar products." The SEC seeks permanent enjoinment from future violations of the securities laws against the Olives and seeks disgorgement, pre- and post-judgment interest, as well as monetary penalties. We The People settled the SEC's charges by agreeing to a judgment that provides injunctive relief, as well as orders payment of disgorgement and the appointment "of a receiver to protect the more than $60 million of investor assets still held by We The People."

A separate complaint was filed against William Reeves, We The People's in-house counsel, for his alleged involvement in the scheme. Reeves has settled the charges by agreeing to a judgment that provides injunctive relief, orders him to pay a civil penalty to be determined at a later date, and suspends him from practicing as an attorney in front of the SEC.

Thursday, February 7, 2013

Securities Class Action Filings Decrease in 2012

By Tim Dulaney, PhD and Tim Husson, PhD

Earlier this year, Cornerstone Research released 2012 review (PDF) of Securities Class Action Filings in conjunction with the Stanford Law School -- the press release can be found in here (PDF).    The report notes that the number of federal securities class action filings have decreased in recent years and, in particular, has fallen nearly 20% from 2011 to 2012.  For the number of filings over the past sixteen years can be found below (Figure 2 in their report).
Cornerstone attributes the majority of the decline in class action filings to the dramatic decrease in filings concerning mergers & acquisitions (M&As) as well as Chinese reverse mergers (CRMs).  The second circuit (NY, etc.) became the most active single venue for securities class actions in 2012 -- 30% of total filings -- after several years with the ninth circuit (Western US, etc.) contending for that title -- 18% of total filings in 2012.

A similar report was almost concurrently released by NERA Economic Consulting.  NERA found 207 federal securities class action filings 2012  and a more modest 8% decrease from the year prior.  For a comparison between these two studies and an explanation of this discrepancy, see the fantastic post by Lyle Roberts over at 10b-5daily.

So what issues might be the source of litigation in the future?  Cornerstone analyzed the 3,001 reports submitted to the SEC under the Dodd-Frank whistleblower program from October 2011 through September 2012.  The breakdown by issue shows a broad distribution of potential infractions:

In general the Cornerstone report suggests that the landscape of securities class actions is changing.  It will be interesting to see if recent regulatory changes, such as full implementation of Dodd-Frank and JOBS Act provisions, will result in a shift in the types of issues that lead to class litigation, or if market changes such as the rise of ETFs or the re-emergence of structured finance will lead to new types of disputes.

Wednesday, February 6, 2013

Call Options on Hedge Funds: Double Markups and Detrimental Mispricing

By Eddie O'Neal, PhD

A recently settled FINRA Arbitration case was brought by an investor who was sold a $2M call option on a basket of hedge funds by a large investment bank.  The case was notable for two reasons.  First, the investment bank charged a 25 percent markup on the fair value of the option.  This large amount was charged even though the investment bank -- call it Investment Bank 1 -- simultaneously laid off all of its risk by buying an equivalent call option from another investment bank -- call it Investment Bank 2.  

Even more interesting is that the markup that Investment Bank 2 charged Investment Bank 1 was also passed along to the investor.  Of course, it would have certainly been much cheaper for the investor to buy the option directly from Investment Bank 2, thereby avoiding the markup of Investment Bank 1.  But Investment Bank 1 did not advise the customer to do that, choosing instead to charge the additional markup in what turned out to be a risk-less transaction for the bank.

The second interesting aspect of the case is how the option was priced.  All of the marketing materials given to the client stated that the option would be priced on the clients account statements according to the Black-Scholes model.  The target volatility of the underlying hedge fund basket was 6%.  Numerous documents showed that indeed the underlying hedge fund basket had 6% volatility.   

However, when the option was sold to the investor, it was priced as though the volatility was 15%.  Higher volatility on the underlying asset leads to higher option prices.  The use of 15% rather than 6% in the Black-Scholes model caused the price paid by the investor to be 37% higher than the fair value calculated with 6% volatility. After the option was sold at the artificially inflated price, internal documents show that the volatility Investment Bank 1 used to price the option declined monotonically from 15% to 6% over the ensuing two and a half years.  This decline in the volatility caused a reduction in the value of the option regardless of the performance of the underlying basket of hedge funds.

At the end of the day, the investor paid $2M for an option that had a value of approximately $1.1M.  The $900,000 overpayment by the investor was a combination of option mispricing by the investment banks and two large markups.

Tuesday, February 5, 2013

More on Non-Traded REIT IPOs-via-Mergers

By Tim Husson, PhD

So far, two large non-traded REITs (Cole Credit Property Trust II and American Realty Capital Trust III) have merged with traded REITs.  Merging with a traded REIT is one way for these otherwise largely illiquid investments to bring their assets to market and allow their investors to cash out.  The more traditional 'exit strategy', and the strategy anticipated by most non-traded REIT offering documents, would be to have an independent initial public offering (IPO).  So why are some non-traded REITs merging instead of having an IPO?

Kaitlin Ugolik at Law360 offers an answer:
The current public trading market tends to value properties higher than the private investor market, [Peter Fass, Proskauer Rose LLP real estate capital markets and finance partnersaid, so many of the strongest nontraded REITs that have amassed a great number of quality assets are turning to the New York Stock Exchange and Nasdaq to get better yields for their investors.
By this argument, private investors who might participate in an IPO are less interested in the assets of a non-traded REIT than a pre-existing traded REIT would be.  The article notes that a traded REIT might be interested in merging with a non-traded REIT in order to increase its overall size, which could increase its access to capital and diversify its portfolio of properties.

However, in both of the mergers we have seen so far, the non-traded REIT has been the much larger entity. Also, most non-traded REIT shares sell in the limited secondary market for a substantial discount to their offering prices. It may be the case that large non-traded REITs are looking to 'purchase' the brand and ticker of a traded REIT rather than risk an IPO based on its own assets.  It will also be interesting to see if smaller or more obviously troubled non-traded REITs also pursue mergers, and what value investors will eventually receive for their shares.

Monday, February 4, 2013

Oppenheimer to Pay US Airways $30 Million over Auction Rate Securities

By Carmen Taveras, PhD

Oppenheimer & Co. has been ordered by a FINRA arbitration panel to pay US Airways $30 million in damages related to the purchase of several series of structured auction rate securities (ARS). The story is being covered by Caitlin Nish at the Wall Street JournalBill Singer at Forbes, and Keith Goldberg at Law360. You can find the award here.

ARS are debt instruments that paid interest rates that reflect the clearing prices of regular auctions. Oppenheimer sold several series of the Camber, Capstan, and Pivot ARS to US Airways. The Camber, Capstan, and Pivot are among the most complex types of ARS, as they are backed by synthetic CDOs. The auctions of these ARS were among the first to fail in the summer of 2007, while most of the ARS market failed in February of 2008. SLCG has written an extensive paper on ARS (PDF) and the factors that led to the auction failures.

The investors in the Camber, Capstan, and Pivot ARS were ultimately exposed to the credit risk of a list of corporate bonds issued by a group of reference entities. Credit-related losses in the portfolio of reference entities translate into reductions in the ARS investors’ principal. Even if the ARS auctions would have cleared, ARS investors could still suffer capital losses since they were the ultimate providers of credit default protection to the originator.

In summary, these securities paid a low return for the high-risk imbedded in the tranching of the portfolio of selected reference entities. Not only were these securities unsuitable for US Airways but they should not have been sold at all.

Friday, February 1, 2013

FTC Releases Report on Debt Buying Industry

By Tim Dulaney, PhD

The Federal Trade Commission (FTC) released their report (PDF) yesterday on the "Structures and Practices of the Debt Buying Industry".   This rather lengthy report brings into focus the industry -- debt collection and debt buying -- that is responsible for more consumer complaints than any other industry.

"Debt buying" is the practice of purchasing debts from creditors.  A creditor may decide that it is unlikely the debtor will repay a debt and as a result may sell the rights to collect the debt for a fraction -- on average four percent according to the report -- of the total debt owed.  The debt buyer can then collect on the debt -- through direct contact with the debtor, litigation, or otherwise -- and realize a profit if the debt is payed.  

The report studied over 5,000 portfolios of purchased debt that held claims on across 90 million consumer accounts.  The average debt per consumer account amounted to almost $1,600.  Of the accounts in the sample, approximately 61% were the result of a creditor "charging-off" the debt -- the creditor believes the debt is unlikely to be collected -- and the remaining 39% were a result of bankruptcy.  The vast majority of the charged-off debt was credit card based, but the largest debt category by average face value was a result of charged-off mortgages.  The amount debt buyers paid for this debt varied significantly depending on the performance of the underlying mortgage -- from over 75% for performing loans to less than 1% for loans on foreclosed properties.

The report finds that although debt buyers "typically received additional information that could make validation notices more useful, [debt buyers] usually did not provide it to consumers."  In addition, debt buyers are usually given limited information at the time of sale and the information is given on an "as is" basis with no guarantees to accuracy.  For example, while virtually all debt bought included information such as account number and current balance, few were given information about the breakdown of the debt into principal, interest and fees.  Less than half of the debt bought even had information about the original creditor.

That this industry faces a large number of consumer complaints is not surprising given the sparse and questionable quality of the data used by this industry.  According to the report, "consumers disputed 3.2% of debts that buyers attempted to collect themselves."  There are a number of steps consumers can take to protect themselves from collectors with incorrect data concerning their debts.
  1. Verify the information concerning the debtor to insure that the collector is not mistakenly contacting the wrong person.
  2. Ask for all information pertaining to the debt, including the account number, original creditor, breakdown of debt into principal, interest and fees.  Debt buyers often have limited access to the documentation and obtaining such documentation could eat into their profits and discourage the continued collection attempts.  
  3. Obtain the age of the debt being collected and determine whether or not the debt is past your state's statute of limitations on the type of debt (sometimes as low as three years for credit card debt according to the report).  
  4. If all else fails, dispute the debt in writing in accordance with Section 809(b) of the Fair Debt Collections Practices Act
Hat tip to Chris Morran at the Consumerist for bringing this report to our attention.

SEC Litigation Releases: Week in Review

SEC Charges Five Former Executives of Cay Clubs Resorts and Marinas in $300 Million Real Estate Investment Fraud, January 30, 2013, (Litigation Release No. 22607)

According to the complaint (opens to PDF), Cay Clubs Resorts and Marinas' former executives, Fred Davis Clark, Jr., Cristal R. Coleman, David W. Schwarz, Barry J. Graham, and Ricky Lynn Stokes conducted "an offering fraud and Ponzi scheme that raised more than $300 million from nearly 1,400 investors nationwide." Allegedly, from 2004 to 2008, the defendants solicited investors "by promising investors immediate income from a guaranteed 15% return, instant equity in undervalued properties, historic appreciation, development of a network of luxury destination resorts at its nationwide locations, at least $30,000 of unit upgrades, and a future income stream through the rental program Cay Clubs managed." However, in reality the defendants used investor funds to pay themselves salaries and commissions "in excess of $30 million," and Clark and Coleman "misappropriated millions of dollars of investor funds to purchase airplanes, boats, and to pay for unrelated business ventures that included investments in precious metals and a liquor distillery that produced Pirate's Choice Rum." The SEC has charged the defendants with violating various provisions of the securities laws and seeks disgorgement, prejudgment interest, civil penalties, permanent enjoinment from future violations, and an order to repatriate assets.

Securities and Exchange Commission v. Blake R. Wellington and Daniel J. Vance, January 30, 2013, (Litigation Release No. 22606)

Two of Clear One Health Plans' employees, Daniel Vance and Blake Wellington, have been charged with insider trading on confidential information about the merger negotiations between Clear One and PacificSource Health Plans. Vance, an information technology specialist, learned of the merger "when he was asked by Clear One's CEO to help resolve an e-mail issue." Vance then shared this information with Wellington, his supervisor, and the two allegedly then traded on this information, gaining over $70,000 in illicit profits. The defendants have agreed to pay over $154,000 combined in disgorgement, interest, and penalties to settle the charges.

Court Enters Final Judgments, By Consent, January 30, 2013, (Litigation Release No. 22605)

Final judgments were entered against Kurt S. Hovan, Hovan Capital Management, LLC, Lisa B. Hovan and Edward J. Hovan, Jr., for their alleged "fraudulent use...of 'soft dollars.'" The defendants were enjoined from violating various provisions of the securities laws, and ordered to pay $240,000 combined in disgorgement and civil penalties. However, payment of $50,000 in disgorgement has been waived for Edward Hovan due to his financial condition.

Yitzchak Zigdon Settles SEC Fraud Charges, January 29, 2013, (Litigation Release No. 22604)

A final judgment was entered against Yitzchak Zigdon "in the SEC's enforcement action against seven defendants concerning the common stock of CO2 Tech Ltd." According to the SEC's 2011 complaint, Zigdon and the other defendants conducted a scheme  that enabled them "to sell CO2 Tech stock at artificially inflated prices, resulting in profits of over $7 million." Zigdon has been permanently enjoined from violating sections of the Securities Act and the Exchange Act, has been ordered to pay over $464,000 in disgorgement, interest, and civil penalties, and has been barred from "participating in an offering of penny stock."

SEC Sues to Halt Houston-Area Investment Scheme Targeting Lebanese and Druze Communities, January 29, 2013, (Litigation Release No. 22603)

According to the complaint (opens to PDF), from 2007 to 2012 Firas Hamdan defrauded at least 33 investors from "the Houston-area Lebanese and Druze communities, raising more than $6 million" from them. Hamdan promised investors "annual returns of 30 percent" by conducting "high-frequency trading using a supposed proprietary trading algorithm." In reality, Hamdan's method "was a dismal failure, generating $1.5 million in losses." Not only did Hamdan allegedly lie to investors on multiple occasions, but he also "showed them phony documentation to support his false claims." The SEC has charged Hamdan with violating sections of the Exchange Act, and seeks a temporary restraining order, permanent injunctions, and payment of disgorgement, prejudgment interest, and financial penalties.

SEC Charges Former Jefferies Executive with Defrauding Investors in Mortgage-Backed Securities, January 29, 2013, (Litigation Release No. 22602)

According to the complaint (opens to PDF), Jesse Litvak, former managing director of Jefferies & Co., Inc. made "misrepresentations and engag[ed] in misleading conduct while he sold mortgage-backed securities (MBS) in the wake of the financial crisis." From 2009 to 2011, Litvak allegedly "lied to, or otherwise misled, ...customers about the price at which Jefferies had purchased the MBS before selling it to another customer and the amount of his firm's compensation for arranging the trades." The SEC has charged Litvak with violating the antifraud provisions of the securities laws and seeks permanent enjoinment from future violations, payment of disgorgement, prejudgment interest, and civil penalties.