Friday, August 30, 2013

SEC Litigation Releases: Week in Review

SEC Charges Oklahoma Investment Adviser and Cohort with Fraud, August 27, 2013, (Litigation Release No. 22789)

According to the complaint (PDF), former investment adviser Larry J. Dearman, Sr. "invested his clients in various businesses that" his close friend, Marya Gray, "owned in Bartlesville, Oklahoma." According to the SEC, Dearman and Gray misled investors "about the safety of the investments and how their funds would be used, telling them, for instance, that investor funds would be used to purchase equipment for one of Gray's companies, Bartnet Wireless Internet, Inc" while in reality investor funds were used "on gambling, personal expenses, and Ponzi payments." In addition to the alleged misuse of funds, Dearman allegedly "stole roughly $700,000 from some of his clients through various ruses."

The SEC has charged the defendants with violating various sections of the securities laws and seeks "permanent injunctive relief, disgorgement plus prejudgment interest, and civil monetary penalties." The complaint also named "three of Gray's businesses, including Bartnet Wireless Internet, Inc., The Property Shoppe, Inc., and Quench Buds Holding Company, LLC," as relief defendants in order "to recover funds they derived from Defendants' fraud."

SEC Obtains Final Judgment Against Jonathan C. Gilchrist for Fraud and Registration Violations, August 27, 2013, (Litigation Release No. 22788)

A final summary judgment was entered against Jonathan C. Gilchrist that found he had "violated the antifraud and registration provisions of the federal securities laws." According to the SEC, "Gilchrist, acting as the president and chairman of Mortgage Xpress, Inc. (subsequently renamed The Alternative Energy Technology Center, Inc.), authorized the unregistered offer and sale of six million company shares to himself and two entities he controlled." He then used "effected match trades in company securities through brokerage accounts he controlled" driving up the share price. "Into this inflated market, Gilchrist made unregistered sales of 229,661 shares, which the Court found generated illicit proceeds of $692,146.38." The final judgment "bars Gilchrist from serving as an officer or director of any company that is required to register its securities with the Commission, from acting as a broker or dealer, and from trading in stocks with a per share price [of] less than five dollars." Additionally, the judgment orders Gilchrist to pay over $840,000 in disgorgement and prejudgment interest.

SEC Files Action Against Investment Adviser to Enforce Compliance with Order to Pay Disgorgement of Misappropriated Investor Funds, Interest and Civil Penalties, August 23, 2013, (Litigation Release No. 22787)

The SEC filed an application against Anthony T. Vicidomine and North East Capital, LLC, "alleging that they violated an SEC Order requiring them to pay $346,132.04" in disgorgement and prejudgment interest. According the SEC's original complaint, Vicidomine, "the sole principal of North East Capital, LLC,...misappropriated $189,415 from the North East Capital Fund LP...by charging the Fund unearned 'incentive fees.'" Vicidomine then allegedly used these funds for his "other business ventures" and for personal expenses. The SEC's application "seeks a district court order enforcing its August 16, 2013 Order requiring Vicidomine and North East to pay $346,132.04 in disgorgement, prejudgment interest and civil penalties."

Thursday, August 29, 2013

Regulators Soften on Credit Risk Retention Rule

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

Yesterday financial regulators proposed a revised rule addressing the retention of credit risk for sponsors of securitizations -- the proposed rule can be found here (PDF).1  The thought is that by removing the separation between the origination and securitization of loans, lenders will focus more on the quality of loans rather than the quantity, as they would have to keep some 'skin in the game' when structuring asset-backed securities.

The original March 2011 proposal (PDF) required securitizers to retain at least 5% of the credit risk for any risky assets that do not satisfy the requirements of a "qualified residential mortgage" (QRM).  One of the main differences between the original proposal and the new proposal is the QRM definition.

In the original proposed rule, a QRM is "closed-end credit transaction to purchase or refinance a one-to-four family property at least one unit of which is the principal dwelling of a borrower". The mortgage must have a term of at most 30 years and must be secured by a first-lien.  In addition, the borrower must satisfy certain credit requirements including a relatively clean credit report (e.g. no currently past due obligations, etc.), income requirements (debt-to-income ratio not to exceed 28%) and the borrower must put down a 20% down payment (loan-to-value ratio of at most 80%).

Both banks and consumer advocates criticized the original proposal since the overly restrictive requirements on the mortgages would "drastically limit affordable mortgage financing options".  In addition, policymakers criticized the rule fearing that limiting financing options would likely stifle the recovery in the housing market.  The collected comments on the original proposal can be found here.

The proposal's latest incarnation broadens the definition of a QRM and makes the definition consistent with the Consumer Financial Protection Bureau's (CFPB) Qualified Mortgage (QM) Standard (PDF).2  According to the President of the American Banker's Association, the broader definition of a QRM will let lenders issue relatively high-quality mortgages and possibly make loans cheaper since they could sell them in the secondary market.

Of course, by broadening the definition of a QRM, the proposed rule also weakens investor protections by allowing lenders to originate lower quality mortgages and then effectively remove any credit risk from their books through securitization.  As SEC Commissioner Gallagher put it, "What is the point of promulgating a risk retention standard and then exempting everything from it?"
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1 The proposed rule was required by Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (PDF).
2 For more information, see the SEC white paper (PDF) "Qualified Residential Mortgage: Background Data Analysis on Credit Risk Retention."

Wednesday, August 28, 2013

Limit Up/Limit Down Rules and the NYSE

By Tim Dulaney, PhD and Tim Husson, PhD

Nearly a year after the "flash crash" of May 6, 2010, the Securities and Exchange Commission (SEC) proposed a "limit up-limit down" mechanism that would limit the trading prices for listed equity securities to within a range near recent prices -- effectively limiting the realizable volatility of the price movements.1  The proposal called for price bands around the average price over the preceding five-minute period and would prevent execution of trades outside of these bands.  The proposal was designed to circumvent trading errors and to damper market volatility.

ETF sponsors quickly backed the new SEC proposal since exchange-traded funds (ETFs) "have continued to be stung by flash crashes in single ETFs."  An associate director of global ETF research at Morningstar said that the "proposal would provide a better experience for investors by avoiding broken trades and other inefficiencies."

A year later, the SEC approved the "limit up-limit down" mechanism with a few alterations to the original plan.  The price bands were defined as "5%, 10%, 20%, or the lesser of $.15 or 75%, depending on the price of the stock."  The first phase of the implementation essentially covered the securities in the circuit breaker program while the second phase would apply more widely.

It turns that out that one major problem with the program is the definition of the word "price".  For securities that don't trade frequently, there may not even be a trade in the last five minutes.  If there are no trades, you'd have to look at orders.  As explained by Ugo Egbunike at IndexUniverse, whether an ETF's trading is halted under the new rules depends on the 'national best bid' (NBB) for that fund, not the price of executed trades.

The NBB was designed to give traders a sense for prevailing market prices; however, some have argued that high frequency traders can manipulate the NBB, reducing its usefulness for practical or regulatory purposes.  In fact, there is some evidence that when 50 ETFs were halted on August 19, 2013, it was due to high frequency trading algorithms manipulating the NBB -- not as a result of trades being executed at large price deviations.  While it is not clear why there were so many halts (or indeed how many is too many), there are some features of the program that could be susceptible to some forms of high frequency trading.

The New York Stock Exchange (NYSE) lifted the limit rules yesterday on over 500 ETFs because of their relatively infrequent trading (an average of 10,000 times per day or less).  For these ETFs, the quotes on which the limit-up/limit-down system is based "can zip around based on available liquidity."

It will be interesting to see whether the SEC or the NYSE change the proposed rule to look at actual trades rather than NBB quotes (more akin to the previous system).  While actual trades in relatively illiquid ETFs may be infrequent, it may be less susceptible to manipulation from high frequency traders.
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This proposal expands upon the 18 month trial single-stock circuit breaker program introduced by the SEC in June 2010 immediately following the flash crash.  This program applied to S&P 500 stocks, Russell 1000 stocks and to a list of exchange-traded products that track stock indexes.

Monday, August 26, 2013

Cat Bonds and Contamination Risk

By Tim Dulaney, PhD and Tim Husson, PhD

Many pension funds have struggled to achieve sufficient return on their investments in the current low interest rate environment.  Some have begun investing in insurance-linked securities, particularly catastrophe ('cat') bonds.  You can find our primer on insurance-linked securities here; essentially, insurance companies issue cat bonds to transfer the risk of catastrophic losses to investors, meaning cat bond investors suffer losses in the event of a major disaster.

While such risk might be considered unsuitable for a pension fund, recently issued cat bonds also have another potentially risky feature that could lead to widespread losses under certain circumstances.  These cat bonds are called 'cat bond-lite' structures.

Traditional cat bonds are created through a special purpose vehicle (SPV), a separate legal entity often domiciled in the Cayman Islands or other legally favorable offshore location.  SPVs are also used by CDOs and other complex structured securities as a way of separating the assets linked to the security from the rest of the issuer's assets.  That way, if the deal goes awry, only the assets in the SPV are at risk, limiting insolvency risk to some extent.  However, setting up an SPV might be relatively expensive.

In a cat bond-lite transaction, the cat bond's assets are held by segregated account companies (SAC), which may issue many cat bonds on behalf of many issuing insurance companies.1  While in some circumstances this may be sufficient separation to avoid any contamination or insolvency issues, some legal experts are concerned that cat bond-lite structures may increase systemic risk in the insurance-linked securities market:
There might be some marginal cost increases [for using an SPV over an SAC] but they really are on the edges. Whenever I've looked at it I've concluded [an SAC] was introducing vulnerabilities for something that doesn't really have that many advantages.
What this means for pension funds is that cat bond-lite transactions expose pension funds to not only the risk of loss stemming from particular major disasters, but also to insolvency risk of cat bond-lite SACs.  While many of the legal ramifications of cat bond-lite structures remain untested, the controversy does shed some new light on the growing market for cat bonds and insurance-linked securities.

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1 The first cat bond-lite transaction occurred in the summer of 2010.

Friday, August 23, 2013

Morgan Stanley's Excessive Municipal Bond Markups

By Tim Dulaney, PhD and Tim Husson, PhD

Yesterday, FINRA fined Morgan Stanley for best execution and for charging excessive markups or markdowns. We have been covering markups extensively, and we have taken the Morgan Stanley municipal bond transactions identified by the FINRA action and applied our markup calculation methodology to calculate the distribution of markups charged by Morgan Stanley.

Let's start with an example. FINRA flagged a customer purchase of $145,000 in a West Virginia municipal bond (CUSIP: 95639RBW8) on September 19, 2008 at 11:01 AM. Morgan Stanley sold this bond to the customer at a price of $99.64. Looking at the EMMA trade data for this bond, we can identify this transaction exactly.



We can also see that at 8:27 AM that same day, there was a much larger inter-dealer trade for only $88.70! That's a markup of over 12% or more than 8 times the median markup of similar sized bond trades.

The average interdealer price on September 19, 2008 was $88.60 and the average interdealer price on September 18 and 19, 2008 was $88.06. There were 5 other, smaller, customer purchases of this bond on September 18 and September 19 with a weighted average price of $92.25. Morgan Stanley charged this customer $7.41 more per bond than other customers making smaller purchases in the same bond at the same time were being charged.

This matches a very similar pattern to other municipal bond markups we have identified before.

We compared the distribution of estimated markups from a sample of over 13.5 million customer trades in fixed-coupon, long-term municipal bonds to those mentioned in the Morgan Stanley AWC.

The following figure shows the 50th percentile markup, 71st percentile markup and 95th percentile markup for the distribution of fixed-rate, long-term customer trades from our large sample. Also included in this figure are the individual Morgan Stanley customer purchases mentioned by FINRA that had a corresponding match in the EMMA data. The majority of the AWC purchases are for less than 100,000.

Many of the markups charged by Morgan Stanley and identified by FINRA were less than 5% of the bond's market price. The so-called '5% Policy' -- that markups charged above 5% of prevailing market prices constitute excessive -- has been challenged by many, and in 2011 FINRA proposed scrapping the term altogether (PDF). Yesterday's action against Morgan Stanley suggests that even markups under 5% can be excessive and subject to restitution.

47 of the 165 municipal bond transactions could not be found in EMMA trade data. This is an issue we have discussed before in the context of municipal bond ETFs, whose transactions also do not always appear to be reflected in EMMA, or sometimes appear in the wrong direction (purchases as sales and vice versa). It may be that the data reported to EMMA is either incomplete, inconsistent (with some reported prices including markups while others do not), or contains erroneous entries.

Our colleagues' research suggests that excessive markets are endemic to the municipal bond market, and that retail investors have been charged over $10 billion in markups by brokers over just the last eight years. This FINRA action may only be the first of many actions against brokers for this potentially very common issue.

SEC Litigation Releases: Week in Review

SEC Settles Claims Against Ebrahim Shabudin Arising from Understated Bank Losses During Financial Crisis, August 22, 2013, (Litigation Release No. 22786)

Earlier this month, the SEC's claims against Ebrahim Shabudin (the former Chief Operating Officer of UCBH Holdings, Inc.) were settled. The SEC "alleges Mr. Shabudin and other defendants concealed losses on loans and other assets from the bank’s auditors and delayed the proper reporting of those losses." To settle the charges, Shabudin has agreed to pay a civil penalty of $175,000, "with the penalty partially reduced by the amount paid as a civil penalty in a related administrative action brought against him by the Federal Deposit Insurance Corporation." Shabudin also consented to a final judgment that enjoins him from future violations of the securities laws and bars him from acting as an officer or director of a public company.

Court Enters Final Judgments by Consent Against SEC Defendants Giuseppe Pino Baldassarre and Robert Mouallem, August 21, 2013, (Litigation Release No. 22785)

On August 16, final judgments were entered against Giuseppe Pino Baldassarre and Robert Mouallem for their alleged involvement in "a fraudulent broker bribery scheme designed to manipulate the market for the common stock of Dolphin Digital Media, Inc." The final judgments permanently enjoin the defendants from future violations of the securities laws, order them to "pay total combined disgorgement and prejudgment interest of $21,932.03, which is deemed satisfied by the forfeiture orders entered against them in a parallel criminal action," and bar them from participating in the offering of penny stock. Additionally, an officer and director bar has been put in place against Baldassarre.

Federal Court Permanently Enjoins Atlanta-Area Registered Representative Blake Richards from Securities Fraud Violations, August 20, 2013, (Litigation Release No. 22784)

Earlier this week, an order of permanent injunction was entered against Blake Richards, which enjoins him "from further violations of the securities laws in connection with allegations that the registered representative misappropriated investor funds." According to the SEC, Richards "misappropriated approximately $2 million from at least seven investors." The order determined that "the issues of disgorgement and civil penalties will be resolved on motion of the Commission at a later date."

Securities and Exchange Commission v. Robert Narvett and Shield Management Group, Inc., August 19, 2013, (Litigation Release No. 22782)

According to the complaint (PDF), Robert Narvett and his company, Shield Management Group, Inc., defrauded investors of at least $940,000. Narvett allegedly raised the "funds though the fraudulent offer and sale of promissory notes issued by Shield" and then misappropriated these funds for his personal use. The complaint charges the defendants with violating the Securities Act and Exchange Act, and seeks permanent injunction, disgorgement, prejudgment interest, and civil penalties.

Thursday, August 22, 2013

Morgan Stanley Fined over Excessive Bond Markups

By Tim Dulaney, PhD and Tim Husson, PhD

Morgan Stanley has been fined by the Financial Industry Regulatory Authority (FINRA) for "failing to provide best execution in certain customer transactions involving corporate and agency bonds, and failing to provide a fair and reasonable price in certain customer transactions involving municipal bonds" according to today's news release.  The story has also been picked up by the Bond Buyer and Law360, and you can find the complete acceptance, waiver and consent (PDF).

This action reflects the increased attention being paid to markups on bond trades.  We spent an entire week covering municipal bond markups here on the SLCG Blog, highlighting our colleagues' recent research paper showing billions of dollars in excessive markups charged on US municipal bond transactions.  Today's action might be just the beginning in a larger crackdown on these excessive charges.

This action related to 165 municipal bond transactions, as well as 116 corporate and agency bond transactions.  We have analyzed those municipal bond transactions and compared their markups to those in the wider municipal bond market -- you can find those results in our followup post.

Wednesday, August 21, 2013

Update on Inland American Non-Traded REIT

By Tim Dulaney, PhD and Tim Husson, PhD

Inland American Real Estate Trust, the largest non-traded real estate investment trust (REIT), has been the subject of intense scrutiny.  In many ways, the criticism of Inland American has been representative of the issues endemic to non-traded REITs generally, such as poor dividend coverage, conflicts of interest, excessive payments to affiliates, stale or poorly updated share prices, and other issues we have discussed on this blog and in our research work (PDF).  While these issues have been known for some time, there is still a lot happening in the non-traded REIT space, and with Inland American in particular.

According to the Direct Investments Spectrum, Inland American is still by far the largest non-traded REIT by total assets, with approximately $10.7 billion as of March 31, 2013.  The next largest, Cole Credit Property Trust II, had only $7.3 billion, and Columbia Property Trust (formerly known as Wells REIT II) came in third with $5.6 billion.

Like most non-traded REITs, Inland American was originally sold at a fixed share price of $10 per share, even after the real estate collapse of 2007-8.  Once FINRA began requiring updated per share net asset values, Inland American reported a value of $8.03, and which has most recently been reported at $6.93.  However, this is not necessarily the price investors could obtain for selling their shares, as non-traded REITs are largely illiquid, and share repurchase programs often have restrictions and limits.  The most recent tender offer on Inland American shares is for $5.00 per share.

Price History of Inland American Real Estate Trust
Inland American has been the subject of an SEC investigation since at least May 2012.  While the details of that investigation remain unclear, it has been suggested that the SEC is focusing on the disclosure of property valuations and management fees.  As we noted previously, Inland American uses a network of affiliated entities to provide services to the non-traded REIT, many of which collect significant fees on new funds raised, real estate operations, or distributions to investors.

Indeed, in March 2013 Inland American was sued by investors over payments to an affiliate, Inland American Business Manager & Advisor Inc.1 The affiliate collected a 5% fee on distributions to investors, and was able to collect $185 million in fees between 2005 and 2012.  The suit alleges that those fees were inflated because the 'distributions' to investors were actually return of capital -- a common criticism of non-traded REITs.  Even as of the first quarter of 2013, Inland American was paying higher distributions than its modified funds from operations, according to the Direct Investments Spectrum.

We will be watching these investigations closely.  As many of these criticisms also apply to other non-traded REITs, these investigations may have important implications for the entire $87 billion non-traded REIT industry.

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1 The case is William Trumbo et al. v. The Inland Group Inc., filed in the Circuit Court of Cook County, Illinois.  You can find the complaint here (PDF).

Tuesday, August 20, 2013

Falcone the First To Admit Guilt Under New SEC Settlement Policy

By Tim Dulaney, PhD and Tim Husson, PhD

On Monday, Philip Falcone and Harbinger Capital Partners, LLC, the hedge fund he founded in 2001, agreed to a settlement with the Securities and Exchange Commission (SEC) that in addition to an $18 million penalty included an admission of wrongdoing.1  This is the first high-profile settlement with an admission of guilt since SEC Chairman Mary Jo White said the commission would seek more admissions of guilt rather than continue its longstanding policy of allowing defendants to 'neither admit nor deny' claims of fraud.

The SEC's Enforcement Division had previously reached a settlement with Falcone and Harbinger, but that agreement was rejected by SEC commissioners who reportedly deemed the deal too weak.  Monday's settlement is essentially the same dollar amount but increases the ban to five years for Mr. Falcone.  The additional admission of wrongdoing could represent a major step in the Commission's enforcement policy and could grease the wheels of potential civil and criminal cases against the embattled fund manager.

Falcone's case could have implications for the SEC's other investigations, including the infamous "London Whale" case against JP Morgan regarding derivatives losses.  Indeed, if the SEC is able to obtain admissions of wrongdoing in other cases, more criminal charges could be brought for securities fraud, effectively stepping up enforcement and penalties.

But there is another important implication as well.  The SEC's former 'neither admit nor deny' policy made it difficult for the public to definitively know whether a particular fraud occurred, or if the defendant merely accepted settlement to avoid prosecution.  This meant that investors could not ascertain the risk of such fraud in the future.  In fact, in 2011 a New York federal judge dismissed a $285 million SEC settlement with Citigroup on the grounds that its 'neither admit nor deny' clause prevented the court from determining guilt.

Monday's settlement brings to a close a long battle between the SEC and Mr. Falcone.  But it also could signal a new era at the SEC, one in which enforcement of securities laws does not end with a settlement agreement.

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The settlement stems from charges filed by the SEC in the June 2012 complaint (PDF).

Monday, August 19, 2013

Banks Water Down Loan Terms in Quest for Growth

By Tim Dulaney, PhD and Tim Husson, PhD

The Global Association of Risk Professionals (GARP) is reporting that banks are watering down terms of new loans under competitive pressure.  For example, some banks are increasing the length of amortization from the usual 15 years to the 25 years, others are decreasing required debt-service coverage from 1.25 to as low as 1 times cash flow while still others are waiving cancellation/prepayment fees.

The relaxation of loan standards is not unique to the commercial loan industry.  Recently, terms of residential mortgages and home loans have seen similar relaxation as home prices have been steadily increasing.  The Mortgage Credit Availability Index (MCAI) also indicates that loan terms have been weakening for the better part of eighteen months.

Of course by offering loans with more lax terms, lenders are exposing themselves to default risks and possibly helping to inflate another bubble.  However, lending standards are still rather tight compared to the heyday of the housing boom.  The MCAI, which is currently at a level of 112, would have been approximately 800 in 2007.

Nonetheless, it is interesting that lenders are competing on loan structure rather than on price.  It may be that banks fear the regulatory implications of over-leveraging, and thus are modifying loan terms as a way of gaining a competitive advantage without appearing overstretched.  Whether these modified loan terms will have repercussions in the senior loan or mortgage-backed securities markets remain to be seen.

Friday, August 16, 2013

SEC Litigation Releases: Week in Review

SEC Obtains Final Judgment Against Conrad M. Black, August 15, 2013, (Litigation Release No. 22781)

According to the complaint (PDF), Conrad M. Black, former Chief Executive Officer of Hollinger International, Inc., "fraudulently diverted money from Hollinger International to himself and other corporate insiders in the form of purported non-competition payments in the PMG Acquisition and Forum Communications Company newspaper sale transactions." Additionally, Black allegedly "made misstatements and omissions of material fact about these related party payments in Hollinger International's filings with the Commission." A final judgment was entered against Black that permanently enjoins him from future violations of the Exchange Act, orders him to pay over $4 million in disgorgement and prejudgment interest to Chicago Newspaper Liquidation Corporation, and prohibits Black from "acting as an officer or director of any public company."

SEC v. Jack Freedman, SEC v. Jeffrey L. Schultz and Redfin Network, Inc., SEC v. Richard P. Greene and Peter Santamaria, SEC v. Douglas P. Martin and VHGI Holdings, Inc.,SEC v. Sheldon R. Simon, SEC v. Thomas Gaffney and Health Sciences Group, Inc., SEC v. Mark Balbirer, SEC v. Stephen F. Molinari and Nationwide Pharmassist Corp., August 14, 2013, (Litigation Release No. 22780)

Last week the SEC charged Thomas Gaffney, Health Sciences Group, Inc., Mark Balbirer, Stephen F. Molinari, Nationwide Pharmassist Corp., Jack Freedman, Jeffrey L. Schultz, Redfin Network, Inc., Richard P. Greene, Peter Santamaria, Douglas P. Martin, VHGI Holdings, Inc., and Sheldon R. Simon with engaging in various schemes involving "undisclosed inducement payments made to individuals to facilitate the manipulation of the stock of several microcap issuers." According to the SEC, "the defendants in the schemes involving undisclosed kickbacks understood they needed to disguise the kickbacks as payments to phony companies, which they knew would perform no actual work" and in the schemes "involving the undisclosed inducement payments or bribe...the defendants knew their illegal activities were meant to artificially inflate the companies’ stock volume and prices." The SEC has charged the defendants with violating sections of the Exchange Act and Securities Act and seeks "permanent injunctions, disgorgement plus prejudgment interest, and financial penalties against all the defendants; penny stock bars against all the individual defendants; and officer-and-director bars against defendants Schultz, Martin, Gaffney, and Molinari."

Securities and Exchange Commission v. Javier Martin-Artajo and Julien G. Grout, August 14, 2013, (Litigation Release No. 22779)

According to the complaint (PDF), Javier Martin-Artajo and Julien Grout, two former traders at JPMorgan Chase & Co., "fraudulently overvalu[ed] investments in order to hide massive losses in a portfolio they managed." According to the SEC, the defendants "deliberately mismark[ed] hundreds of positions by maximizing their value instead of marking them at the mid-market prices that would reveal the losses." This caused "JPMorgan's reported first quarter income before income tax expense to be overstated by $660 million." The SEC has charged Martin-Artajo and Grout with violating sections of the Exchange Act. The SEC's investigation remains ongoing.

Commission Charges Anchor Bancorp Wisconsin and Former CFO with Fraud, August 14, 2013, (Litigation Release No. 22778)

According to the complaint (PDF), Anchor Bancorp Wisconsin, Inc. and its former CFO, Dale C. Ringgenberg, "intentionally or recklessly made material misstatements in Anchor's quarterly Report on Form 10 Q for the period ended June 30, 2009." The defendants consented to final judgments that permanently enjoin them from future vioaltions of the Exchange Act and order Ringgenberg to pay a $75,000 civil penalty, and impose a 5-year officer and director bar against Ringgenberg.

SEC Halts Fraud by Ohio-Based Hedge Fund Manager, August 14, 2013, (Litigation Release No. 22777)

According to the complaint (PDF), Anthony J. Davian through his asset management firm, Davian Capital Advisors, LLC, "raised more than $1.5 million from investors by promoting Davian Capital Advisors, LLC as a highly successful investment management firm" and then "misappropriated at least $1 million in investor proceeds [using] the funds to pay for personal expenses such as the purchase of a luxury home and automobile." Davian has been charged with violating various sections of the securities laws. The SEC received a temporary restraining order and asset freeze against Davian and seeks permanent injunctions, disgorgement of ill-gotten gains, and financial penalties.

15 Year Prison Term for Gregory Mcknight, Orchestrator of $72 Million Ponzi Scheme, August 13, 2013, (Litigation Release No. 22776)

Gregory N. McKnight was sentenced to 188 months in prison followed by 3 years of supervised release and ordered to pay over $48.9 million in restitution for his "role in orchestrating a $72 million Ponzi scheme" through his company Legisi Holdings. These charges arose from the same facts that "were the subject of an emergency action that the Commission filed against McKnight and others on May 5, 2008." In July 2011, a final judgment was entered against McKnight based on the Commission's action that ordered him to "pay disgorgement of ill-gotten gains, prejudgment interest, and civil penalties totaling approximately $6.5 million" and permanently enjoined him from violating sections of the Securities Act and Exchange Act.

Earlier last month, "McKnight's associate Matthew J. Gagnon was sentenced to five years in prison for his role in promoting Legisi."

SEC Charges Former Executive of Massachusetts-Based Company with Insider Trading, August 12, 2013, (Litigation Release No. 22775)

According to the complaint (PDF), Joseph M. Tocci, former executive of American Superconductor Corporation, used insider information he "obtained as the assistant treasurer of American Superconductor to purchase option contracts through which [he] essentially bet that the company's stock price would soon decrease on the release of negative news." Tocci gained over $80,000 in illicit profits based on this trading. Tocci has consented to a judgment that enjoins him from future violations of the Exchange Act and orders him to pay over $170,000 in disgorgement, prejudgment interest, and civil penalties. Additionally, Tocci has agreed to plead guilty in a parallel criminal case.

Thursday, August 15, 2013

Do Leveraged ETFs Increase Stock Market Volatility?

By Tim Dulaney, PhD and Tim Husson, PhD

Leveraged exchange-traded funds (LETFs) are controversial investments.  Because they can be leveraged as much as 3x, and can be linked to highly volatile underlying assets, their daily price movement is typically very dramatic.  Also, LETFs tend to lose value over time if their underlying assets are relatively volatile due to rebalancing effects, something we've covered here before as well as in our research papers (PDFs).

Another concern with LETFs is that they could increase the volatility of their underlying assets.  To see how, consider how a typical LETF achieves its leverage.  If its assets increase in value over the course of a day, the LETF has to purchase more of those assets in order to keep its leverage ratio (2x, 3x, etc.) constant.  If those assets decrease in value, the LETF has to sell some assets for the same reason.  The concern is that if LETFs attract significant assets, these rebalancing transactions could create a positive feedback loop of increased buying in rising markets and increased selling in downward-trending markets.

Recent research from the Federal Reserve (PDF) suggests that just this situation could occur and could have a large effect in the stock market.  In fact, the paper argues that LETFs "contributed to the stock market volatility in the 2008-2009 financial crisis and in the second half of 2011 when the European sovereign debt crisis came to the forefront."  The paper also notes that because LETFs must rebalance every day, that their trading activity "is predictable and may attract anticipatory trading."  This could also exacerbate the positive feedback loop, leading rising stocks higher and falling stocks lower, as we have discussed before.

Interestingly, the paper compares LETFs to 'portfolio insurance strategies' of the late 1980s.  Portfolio insurance is a hedging technique that also effectively requires purchasing assets in rising markets and selling in falling markets.  It is thought to have contributed to the stock market crash of Black Monday (October 19, 1987), when the Dow Jones lost almost a quarter of its value in a single day.

While equity LETFs currently may not be a particularly large fraction of stock market trading, as LETFs expand to other, less liquid asset classes, these rebalancing effects could become more pronounced.  Also, not everyone agrees about the effects of LETF rebalancing.  Unfortunately, we may have to wait for a particularly grim day on Wall Street to truly test this effect.

Wednesday, August 14, 2013

Structured CD with an Exotic Embedded Option

By Tim Dulaney, PhD and Tim Husson, PhD

In the past few months, we have constructed a database of thousands of structured certificates of deposit (CDs).  We have analyzed and evaluated hundreds of these CDs and have compiled these results into a recently completed study (PDF).   Our results indicate that structured CDs are usually issued at significant discounts to face-value (comparable to structured products), offer little if any market exposure and are often less valuable than contemporaneously issued fixed rate CDs.

We've recently come across a structured CD that has some interesting features and we thought we'd take this opportunity to talk about them in some detail.  This particular structured CD pays interest annually at a minimum rate of 1% per annum for five years.  It adds additional contingent interest based on the prices of three common stocks, known as the 'basket'.

The price of each stock in the basket is observed annually.  For a given observation date, if all of the stock prices are at least as high as their respective initial prices when the CD was offered, then the CD pays an additional 5%.  This type of position is known generally as a binary dispersion option, specifically a 'worst-of' binary option (we have covered the basics of binary options in a previous post).  The following table walks through some examples of this calculation, assuming each stock's initial value is $100.

Example 1Example 2Example 3
Stock 1$102$105$130
Stock 2$105$113$99
Stock 3$65$102$140
Interest Rate1%6%1%

At maturity, the issuing bank will return principal and the final interest payment.  The FDIC views each of the interest payments as "incalculable" prior to their crediting and as a result investors are exposed to the credit risk of the issuing bank before these coupons are paid.

This particular CD's value depends on the characteristics of the underlying common stock prices.  For example, if the stock prices are not volatile enough, then when the price of one stock dips below its initial price, the likelihood of increasing back above the initial level is relatively low.  Similarly, if the stock prices are too volatile, there is an increased likelihood that any one of the stocks will decrease in price below its initial price.  We have valued the product for different levels of average volatility and have produced the following figure.2

The value of the structured CD also depends on the correlation of the underlying assets.1  If the underlying assets are generally negatively correlated, then if one of the assets increases above its initial price, one of the other two assets will likely decrease in price.  As a result, we generally expect the product to be more valuable as the average pairwise correlation increases.  We have valued the product for various levels of average pairwise correlation and have produced the following figure.

In addition to the dependence on volatility and correlation, the structured CD's value also depends on the skewness of the underlying return distributions.  If any of the underlying stocks have a return distribution that is very negatively skewed (higher probability of negative returns than positive returns), the deposit will decrease in value relative to the case where each of the stocks has a normal return distribution.

We have determined that there is about a 30% chance that an investor would receive any additional payments from the market exposure throughout the term of the deposit (ignoring skewness).  We find that the structured CDs with this market exposure are at best comparable in value to contemporaneously issued fixed-rate CDs.

It's unlikely that investors will appreciate the complicated dependence this particular structured CD has on the characteristics of the underlying assets.  It will be interesting to see if other products with similar structure continue to be issued.

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1 The returns of two assets are said to be positively correlated if the two assets generally increase and decrease in price at the same time.  On the other hand, the returns of two assets are said to be negatively correlated if when one asset increases/decreases in price, the other asset decreases/increases in price.
2 By relative valuation  we mean the value of the CD with the altered parameter(s) divided by the value of the CD with observed market parameters.  As a result, the relative valuation for a CD with no alteration of parameters is 1 (100%).

Tuesday, August 13, 2013

Another News Service for High Frequency Traders Draws Scrutiny

By Tim Dulaney, PhD and Tim Husson, PhD

The Wall Street Journal is reporting that Need To Know News has come under investigation from the Securities and Exchange Commission for selling early access to government data to high frequency trading (HFT) firms.  This comes as other firms who sell machine-readable market data to HFT, including Thomson Reuters, have also made news for potentially distorting markets.

The WSJ story offers an example of how Need To Know News assisted HFT firms:
A news event on Sept. 2, 2011, shows the critical role of speed in trading. Investors were expecting a positive monthly employment report that morning; instead, the economy added no net new jobs. 
A Swiss investment fund, Da Vinci Invest AG, got this number a fraction of a second after its release via Need To Know News, zapped from its seat inside the Labor Department. Da Vinci's computers instantly made trades on European markets that within minutes showed a 16% gain, said the firm's founder, Hendrik Klein. 
Need To Know News "was the fastest service" when the firm became a client in 2009, he said, and "they're still the best."
To get this data, Need To Know News allegedly earned media credentials which allowed it to view Labor Department reports early in a process known as a lockup.  Lockups traditionally allowed reporters to write stories on new economic data before it was released to the public, but are now suspected of leaks to HFT firms.

Indeed, the HFT data firm Nanex, LLC has documented numerous examples of market prices moving fractions of a second before news is officially announced. It is not always clear where leaks come from, but it is increasingly clear that even a few millisecond advantage can prove very valuable to HFT firms.  Whether or not this effectively constitutes insider trading, however, remains to be seen.

Monday, August 12, 2013

The Effect of Oil Futures Markets on ETF Investors

By Tim Dulaney, PhD and Tim Husson, PhD

Barron's reporter Brendan Conway is reporting on a relatively rare phenomenon occurring in oil markets that is benefiting some passive investors.  Futures contracts for oil are generally more expensive as the time to expiration increases -- i.e. a contract expiring later is usually more expensive. The story goes that there are costs associated with storing oil and as a result the futures prices reflect the impact of these storage costs.

The current situation in the oil markets is the reverse: futures contracts are actually cheaper than the spot price.  In this case, demand for immediate delivery of physical oil is offsetting the cost of storage making the spot price for oil exceed the price of short-term futures contracts.

Why should investors care?  Well, the way investors gain exposure to the oil markets (beyond at the gas pump) is through investing in futures-based ETFs.  These ETFs gain exposure to commodities by investing in futures contracts.  When the contracts approach expiration, the ETF sells their current holdings and buys futures contracts again.  If later dated futures contracts cost more than shorter dated contracts, then investors are selling cheaper contracts for more expensive contracts.  We explain this effect (negative roll-yield) in detail within a few of our research papers (PDFs).

The current situation is a little different.  Since futures prices are actually lower than the spot price, some ETFs are reaping the benefit of selling more expensive contracts and buying less expensive contracts when rolling over their holdings.

Although investors with holdings in futures-based oil ETFs (e.g. USO) are benefiting from this rare situation, they shouldn't expect it to last.  As demand for immediate delivery decreases, the markets will likely return to the more common state where later dated futures contracts are more expensive.  In this state, futures-based ETF investors will once again be exposed to the detrimental effects of negative roll-yield.

Friday, August 9, 2013

SEC Litigation Releases: Week in Review

SEC Obtains Asset Freeze and Other Relief in $4 Million Offering Fraud, August 8, 2013, (Litigation Release No. 22774)

According to the complaint (PDF), Steven B. Heinz and his company S.B. Heinz & Associates, Inc. orchestrated an offering fraud and $4 million Ponzi scheme since January of 2012. According to the complaint, "Heinz [paid] 'returns' to earlier investors using new investor funds, used investor funds for his own personal purposes and...S.B. Heinz used investor funds to pay business expenses, including the salary for its secretary and its office rent." The SEC obtained a temporary restraining order and emergency asset freeze against Heinz on August 8, 2013. The SEC has charged the defendants with violating sections of the Securities Act and Exchange Act, as well as the Investment Advisors Act, and seeks preliminary and permanent injunctions as well as disgorgement, prejudgment interest, and civil penalties. The complaint also names Heinz's wife, Susan K. Heinz, as a relief defendant and "seeks disgorgement and prejudgment interest from her."

SEC Charges Certified Public Accountant with Violating Commission Suspension Order;
Seeks Disgorgement of Illicit Compensation Received During Suspended Period, August 8, 2013, (Litigation Release No. 22773)

The SEC filed an application (PDF) against Michael H. Taber for his alleged violation of a 2004 Commission Order that "permanently suspended Taber from appearing or practicing before the Commission as an accountant." According to the SEC, Taber continued to work as an accountant from at least 2005 until 2010 after the order was issued. The SEC seeks "a district court order enforcing its 2004 Order suspending Taber from appearing or practicing before the Commission as an accountant, and asks that the court order him to pay $584,650.41 in disgorgement, representing illicit compensation gained as a result of his engaging in work that was proscribed by the 2004 Order" as well as order him to pay "prejudgment interest in the amount of $146,849.02."

SEC Charges Bank of America Entities with Material Misrepresentations and Omissions in Connection with an RMBS Offering, August 7, 2013, (Litigation Release No. 22772)

According to the complaint (PDF),  Bank of America, N.A., Banc of America Mortgage Securities, Inc., and Merrill Lynch, Pierce, Fenner & Smith, Inc. f/k/a Banc of America Securities LLC "made material misrepresentations and omissions in connection with the sale of residential mortgage-backed securities known as BOAMS 2008-A," failing to "disclose the disproportionate concentration of wholesale loans (72% by unpaid principal balance) underlying BOAMS 2008-A as compared to prior BOAMS offerings." The SEC has charged the Bank of America Entities with violating the antifraud provisions of the securities laws and seeks "a permanent injunction, disgorgement with prejudgment interest and civil monetary penalties."

SEC Charges Stock Promoters with Market Manipulation, August 6, 2013, (Litigation Release No. 22771)

According to the complaint (PDF), Cort Poyner and Mohammad Dolah "engaged in a fraudulent broker bribery scheme designed to manipulate the market for the common stock of Resource Group International, Inc. and Gold Rock Resources Inc." The SEC has charged the defendants with violating sections of the Exchange Act and Securities Act and seeks "permanent injunctive relief, disgorgement of ill-gotten gains, if any, plus pre-judgment interest, and civil penalties from Poyner and Dolah, a judgment prohibiting Dolah from participating in any offering of penny stock, and an order prohibiting Poyner from acquiring, disposing or promoting any penny stock."

SEC Charges Penny Stock CEO in International Boiler Room Scheme, August 5, 2013, (Litigation Release No. 22770)

According to the complaint (PDF), former iTrackr Systems CEO, John G. Rizzo, raised over $2 million from United Kingdom investors by "us[ing] offshore boiler rooms to solicit foreign investors as he attempted to evade registration requirements under the U.S. securities laws." Criminal charges have been announced against Rizzo in a parallel action. The SEC has charged Rizzo with violating sections of the Securities Act and Exchange Act and seeks disgorgement, prejudgment interest, financial penalties, officer-and-director and penny stock bars, and a permanent injunction against him.

Securities and Exchange Commission v. Chad C. McGinnis and Sergey Pugach, Defendants, and Bella Pugach, Relief Defendant, August 2, 2013, (Litigation Release No. 22769)

According to the complaint (PDF), a former Green Mountain Coffee Roasters systems administrator, Chad McGinnis traded on insider information before Green Mountain earnings announcements were made. He also tipped his friend, Sergey Pugach, who allegedly "illegally traded in his own account and his mother's trading account." The two gained over $7 million in alleged illicit profits from the trading. The complaint charges the defendants with violating sections of the Securities Act and Exchange Act and names Bella Pugach, Pugach's mother, as a relief defendant.

SEC Charges Two Traders in Spain with Insider Trading Ahead of BHP Acquisition Bid, August 2, 2013, (Litigation Release No. 22768)

On July 30, 2013, the SEC charged Cedric Cañas Maillard, a former executive advisor to Banco Santander's CEO, and his friend, Julio Marín Ugedo, with insider trading "based on non-public information about a proposed acquisition" of Potash Corporation "for which the Spanish investment bank was acting as an advisor." The SEC's "action against Cañas and Marín arises from its continuing investigation into suspicious Potash trading ahead of the Aug. 17, 2010, public announcement of BHP's acquisition bid. A former Banco Santander analyst agreed to pay more than $625,000 to settle insider trading charges by the SEC." The SEC has charged Cañas and Marín with violating sections of the Exchange Act and seeks disgorgement, prejudgment interest, financial penalties, and orders of permanent injunctions against the defendants.

Thursday, August 8, 2013

MSRB Proposes Rule on Muni Bond Markups

By Tim Dulaney, PhD and Tim Husson, PhD

Our colleagues' recent paper on municipal bond markups, which showed that retail investors were charged nearly $11 billion in markups from 2005-2013, has generated a lot of attention.  In June we spent an entire week covering the background, methodology, findings, and implications of that paper, which we think has important implications for the municipal bond investors.

On Tuesday, the Municipal Securities Rulemaking Board (MSRB) proposed a new "fair-pricing" rule that could help address the issue.  According to Kathryn Brenzel at Law360:
Current rules require dealers to trade with customers at “fair and reasonable” prices and to assess market value of municipal securities, according to MSRB. The new rule would address how firms handle bond orders, requiring dealers to evaluate the market, the size and speed of the transaction, the opportunity to get a better price, and the likelihood that the trade will go through, according to regulators.
Kathryn also notes that the proposal stems from a joint Government Accountability Office report (PDF) issued in July 2012, which called on Congress to improve the transparency in the municipal bond market.  The rule may also derive from a proposal last week from the Securities Industry and Financial Markets Association (SIFMA).

The proposal may evolve into a "best-execution" rule similar to FINRA's Rule 5310 ("Best Execution and Interpositioning").  According to the MSRB, the proposed rule is not meant to dilute existing execution requirements but are meant "to impose requirements that are properly tailored for the municipal market".

The "fair-pricing" rule does not, however, propose a hard and fast rule regarding markups.  It will be interesting to see if the new rule is adopted, and if it is, it is specific enough to prevent the kind of excessive markups we have been highlighting for the past few months.

Tuesday, August 6, 2013

Goldman Sachs Sued Over Aluminum Storage

By Tim Dulaney, PhD and Tim Husson, PhD

We mentioned a couple of weeks ago that Goldman Sachs has been in the business of aluminum metal storage for quite a while.  A NY Times investigation found that, through a subsidiary, Goldman Sachs has been artificially inflating the prices of aluminum by magnifying storage costs.

Bloomberg News, the NY Times, and Law360 are reporting that Superior Extrusion Inc., a Michigan-based aluminum processor, has filed a class action lawsuit that alleges Goldman Sachs and the London Metal Exchange (LME) entered into agreements that decreased efficiency in the aluminum market to generate "hundreds of millions of dollars per year in storage revenues during their regime of artificially high storage rates".  The lawsuit -- Superior Extrusion Inc. v. Goldman Sachs Group Inc. et al. --  was filed last Thursday in Federal District Court in Michigan's Eastern District.

The plaintiff alleges that the delays between customer order and delivery have been as long as 16 months. While the LME has been working to "speed up withdrawals from stockpiles in warehouses where waiting times exceed 100 calendar days" and Goldman has made moves to "ease delays at its Metro aluminum warehouses", it seems that this is just too little too late.  

Goldman may have showed the defense's cards a bit when their spokesman pointed out that "aluminum prices are down 40 percent from their peak in 2006".  It will be up to the plaintiff to show that, even in light of this marked decline in aluminum prices, Goldman inflated the prices of aluminum.

The lawsuit comes as investment banks are under scrutiny for their physical commodities businesses.  Just yesterday, the chairman of the Commodities Futures Trading Commission Bart Chilton argued that the Federal Reserve should reverse its policy allowing banks to own such assets, claiming it had "obvious conflicts of interest."  It will be interesting to see whether the issue is settled by regulators, by the courts, or both.

Friday, August 2, 2013

SEC Litigation Releases: Week in Review

SEC Obtains Preliminary Injunction in Binary Options Case, August 1, 2013, (Litigation Release No. 22767)

A preliminary injunction was entered against Banc de Binary Ltd. which enjoins it from offering or selling unregistered securities and acting as an unregistered broker. The SEC filed a complaint in June that charged Banc de Binary with "offering and selling binary options to investors across the U.S. without first registering the securities" and also acting as an unregistered broker.  For more information on binary options, see our introductory post.

SEC Obtains Final Judgment Against Edward O'Connor, July 31, 2013, (Litigation Release No. 22766)

A final judgment was entered against Edward O'Connor, a former director and executive officer of Optionable, Inc., for his "part in a scheme to 'u turn' pricing information from defendant David Lee, a natural gas options trader at Bank of Montreal, back to reviewers at BMO as if the information had been independently verified." The judgment orders O'Connor to pay $700,000 combined in disgorgement and a civil penalty, and permanently enjoins him from future violations of the securities laws as well as imposes an officer and director bar against him.

SEC Charges Former Officers and Investor in Houston Company in Fraudulent Penny Stock Scheme, July 31, 2013, (Litigation Release No. 22765)

According to the complaint (PDF), "PGI Energy's former Chief Investment Officer, Robert Gandy, and former CEO and Chairman, Marcellous McZeal, engaged in a scheme that included creating false promissory notes, signing misleading certifications, and altering the company's balance sheet" so that its transfer agent would "issue millions of PGI Energy common stock shares without restrictive legends." Additionally, the complaint charges "investor Alvin Ausbon for his role in the scheme, which included signing false promissory notes and diverting proceeds from the sale of PGI Energy stock back to the company and Gandy." Their scheme collapsed in February 2012 when "the SEC ordered a temporary suspension of trading in PGI Energy's securities, due to questions regarding the accuracy and adequacy of the company's representations in press releases and other public statements." The SEC has charged the defendants with violating the Securities Act and Exchange Act and seeks permanent injunctions, disgorgement, prejudgment interest, financial penalties, and penny stock bars against all three defendants, as well as officer and director bars against Gandy and McZeal.

McZeal has agreed to a final judgment that orders him to pay almost $90,000 in disgorgement, prejudgment interest, and penalties and enjoins him from future violations of the securities laws. McZeal has agreed to the officer and director and penny stock bars, as well being barred from appearing before the SEC as an attorney.

SEC Files Settled Charges Against John M. Sensenig, Founder and Owner of Conestoga Log Cabin Leasing, Inc. for Fraud and Unregistered Sales of Securities Violations, July 30, 2013, (Litigation Release No. 22764)

The SEC charged John M. Sensenig, a Mennonite community member, with violating various provisions of the securities laws. Sensenig allegedly raised millions of dollars from 1997 until 2009 "from more than 1,500 fellow members of the Amish and Mennonite communities through the offer and sale of Promissory Notes." He then allegedly used these "proceeds to finance a collection of start-up companies he founded and controlled, the largest of which was Conestoga Log Cabin Leasing, Inc." However, over " half of the funds raised by Sensenig were returned to investors." Additionally, Sensenig allegedly "made material misrepresentations and omissions to investors including failing to disclose the use of proceeds, the risks associated with the investment, and remedial sanctions placed on him by a state securities regulator."

A final judgment was entered against Sensenig which permanently enjoins him from future violations of the Securities Act, permanently enjoins him from "direct or indirect participation in any unregistered offerings of securities," orders him to pay a $131,500 civil penalty, and orders him to "surrender for cancellation all shares of stock he owns in two privately held companies formerly affiliated with Conestoga Log Cabin Leasing, Inc."

SEC Charges Tipper of Confidential Information to S.A.C. Capital Portfolio Manager, July 30, 2013, (Litigation Release No. 22763)

The SEC amended its complaint (PDF) against Richard Lee "to additionally charge Sandeep Aggarwal, a sell-side analyst who tipped Lee in advance of a July 2009 public announcement about an Internet search engine partnership between Microsoft and Yahoo." Criminal charges have also been announced against Aggarwal. A final judgment was entered against Lee and Aggarwal which orders them to pay disgorgement, prejudgment interest, and financial penalties, and permanently enjoins them from future violations of the securities laws.

SEC Charges Houston-Based Investor Relations Executive with Insider Trading in Stocks of Clients, July 30, 2013, (Litigation Release No. 22762)

According to the complaint (PDF), Stephen B. Gray, a "former CEO of a Houston-based investor relations firm," traded on non-public information that he learned from the firm's clients. He allegedly profited and avoided losses of more than $131,000 from the illicit trading. Gray was fired from the firm last October when it learned of the SEC's investigation. The complaint charges Gray with violating sections of the Securities Act and Exchange Act and seeks disgorgement, prejudgment interest, financial penalties and permanent injunctive relief.

Municipal Bonds Trading in ETFs

By Tim Dulaney, PhD and Tim Husson, PhD

About a month ago, we spent a full week highlighting research (PDF) conducted at our firm that shows the degree to which investors are harmed by excessive markups in municipal bond trading.  In the paper, our colleagues argue that low-cost improvements in disclosure requirements could largely eliminate these transfers of wealth from taxpayers and investors to the brokerage industry.

After the research was completed, we began thinking about other ways investors gain exposure to municipal bonds.  For example, investors can buy shares of a fund whose assets are municipal bonds.   As a result, we began looking into municipal bond funds to determine the typical markup charged on their trades.

To begin our analysis, we looked at one of the largest municipal bond exchange traded fund (ETF):  SPDR® Nuveen Barclays Short Term Municipal Bond ETF (SHM).  We obtained the daily holdings for the first half of 2013 via Bloomberg and determined dates on which the holdings of the fund changed (implying a trade).

Using these lists of bonds held by the fund, we obtained the trading activity for each municipal bond from the Electronic Municipal Market Access (EMMA) website.   At this point, we attempted to reconcile the trading activity implied by the fund holdings with the trading activity given by EMMA.  For example, if the fund increased the position in a given bond, the EMMA data should reflect a "Customer bought" order for the same amount around the same time.

Let's look at one example that is consistent with our intuition.  On February 14, 2013, SHM increased its holdings of a municipal bond with a CUSIP of 208418NN9 by $695,000 according to Bloomberg.  EMMA has the following data for the bond around this date.
There is a transaction on February 12 in the same amount that is denoted as a "Customer bought", consistent with the interpretation that the fund bought the bonds on or about this date.

Now let's look at another time that SHM increased its position.  On March 22, 2013, SHM increased its holdings of 403755L74 by $1,325,000.  EMMA has the following data for the bond around this date.


The only trade occuring around this date with the correct trade amount is a "Customer sold" order on March 20, 2013.  Given the previous example, it's not clear how this is consistent.

Finally, on March 12, 2013, SHM increased its holdings of 613340V39  by $5,000,000.  The following image is all of the trading activity EMMA has for the bond.


You can see that there is no "Customer bought" or "Customer sold" trades to match with this change in position -- in fact, there are no trades at all within several months of the transaction date!

This same phenomenon also exists for fund sales:  sometimes it is reflected with a "Customer sale" in the EMMA data, sometimes it is reflected in a "Customer bought," and sometimes it is not reflected at all.  We have also attempted to piece together a trade that would match the fund transaction from several smaller trades in the EMMA data around the same time, with limited success.  It thus appears that the EMMA data and the fund position data from Bloomberg are sometimes inconsistent.

Earlier this week, the Municipal Securities Rulemaking Board (MSRB) announced that "it is seeking additional public input on transforming the public display of real-time trade prices on its Electronic Municipal Market Access (EMMA)".  One question that our analysis raises is how complete the EMMA data really is, and if it fully reflects ETF transactions.  This information is important for retail investors, who may want to know whether they are charged larger or smaller markups than those charged to institutional investors.
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UPDATE (12:15PM): The last bond we referenced (CUSIP:  613340V39) changed from the SPDR Nuveen Barclays Municipal Bond ETF (TFI) to the SPDR Nuveen Barclays Short Term Municipal Bond ETF (SHM), both held in the SPDR Trust.  The 2007 5% Montgomory County, MD General Obligation bond can be found in TFI's portfolio in the December 31, 2012 report (PDF) and in SHM's portfolio in the March 31, 2013 report (PDF).  Therefore, the bond may have been transferred from one SPDR portfolio to another.  Perhaps this kind of transaction is not reflected in the EMMA data, but we'll keep tracking this issue down.

Thursday, August 1, 2013

FINRA's Market Data Center

By Tim Dulaney, PhD and Tim Husson, PhD

FINRA has a number of useful web-based tools on their website.  We mention their BrokerCheck tool quite often, as it allows investors to check on the professional background and disciplinary history of any particular broker or firm registered with the agency.  Another very useful tool is their Market Data Center, which provides a wide variety of market data for free.

Perhaps the most useful aspect of the Market Data Center is the the TRACE (Trade Reporting and Compliance Engine) database.  TRACE tracks the trade history of corporate bonds, both investment grade and high yield, in a similar fashion as the MSRB's EMMA (Electronic Municipal Market Access) system tracks municipal bonds.  We've written a whole series of posts about EMMA, which allows investors to assess whether or not they have been charged excessive markups on municipal bond trades.

Investors can use a similar method to assess corporate bond trades using TRACE.  In the Bond Section, you can type in an issuer or CUSIP to find a variety of data and metrics for any particular bond, including its trade history (see an example trade history here).  This free tool offers investors a great deal of information and transparency that would otherwise require a (very expensive) Bloomberg subscription or other proprietary data source.

In fact, just this Monday FINRA expanded its TRACE system to include agency pass-through mortgage-backed securities (MBS) and Small Business Administration (SBA) backed securities.  They also have plans to expand their database even further, adding securities "backed by credit card receivables, automobile and student loans, and a variety of other credits."  These efforts to increase market transparency help retail investors and market analysts understand these relatively complex securities.