## Thursday, October 28, 2010

### SEC Press Release: Fraud in Forex Trading

SEC Charges Massachusetts-Based Forex Traders and Their Firm With Fraud

The U.S. Securities and Exchange Commission (SEC) issued a press release today announcing that it had
charged two foreign currency traders and their Boston-based company with operating a fraudulent scheme in which they sent investors misleading account statements while stealing their funds and incurring major trading losses.

The SEC alleges that Karlis and Akyil raised approximately $40 million from investors for a foreign currency trading venture. They pocketed the money for themselves as well as used it for operations and other business ventures that they were running. Here are the SEC Complaint and the Litigation Release No. 21712. ## Wednesday, October 20, 2010 ### FINRA Regulatory Notice: Commodity Futures-Linked Securities Sales Practice Obligations for Commodity Futures-Linked Securities The Financial Industry Regulatory Authority (FINRA) published Regulatory Notice 10-51 reminding firms to make fair and balanced statements in its communication with the public on commodity futures-linked securities. They are reminded that the returns on such securities can often deviate from the returns on the underlying commodities to which they track. In an effort to further educate public investors, SLCG has written a draft paper on futures-based commodities ETFs examining, amongst other things, the sources of the deviation between futures-based commodities ETF returns and the underlying commodities returns. It is often claimed that ETFs are good for diversification and hedging, and investors are probably told the same thing by brokerages. But if the returns deviate from the underlying returns, then this claim is not necessarily true. Investors should investigate for themselves. You can find the draft paper and many others at our dedicated website. ### FINRA Press Release: Reverse Convertibles FINRA Orders Ferris, Baker Watts to Pay Nearly$700,000 for Inappropriate Sales of Reverse Convertible Notes

The Financial Industry Regulatory Authority (FINRA) issued a press release today announcing that
it has fined the former Ferris, Baker Watts LLC, acquired by RBC Wealth Management, \$500,000 for inadequate supervision of sales of reverse convertible notes to retail customers as well as unsuitable sales of reverse convertibles to 57 accounts held by elderly customers who were at least 85 years old and customers with a modest net worth.
The settlement is detailed in the FINRA AWC No. 20070091803.

A reverse convertible note is a type of structured product that is linked to an equity security or an index. It is a short-term note that pays a relatively high coupon rate compared to traditional notes. The returns of the note at maturity depends on whether the equity, called ‘reference asset’, falls below a pre-specified trigger price during the term of the note. If it does, then the note returns the market value of the number of shares of the reference asset which could have been purchased on the note’s pricing date with the note’s face value. If it does not, then the note returns its face value.

SLCG has written a paper on the topic including a paper that values and analyzes a large sample of reverse convertible notes. We find that these notes are largely and consistently overpriced, yet reverse convertibles continues to be sold which, combined with the complexity of and the lack of a secondary market for these notes, implies that investors do not fully understand the returns and risks of these notes.

## Friday, October 15, 2010

### In the News: Structured Notes

Bloomberg issued a news release today reporting that the amount of sales and issuances of structured products had reached a record in 2010. The demand for higher yields and caution in investing in stock were factors which contributed to the growth in structured products. According to Bloomberg, a popular structured product was the step-up callable note, which is a callable note that increases (‘steps up’) its fixed rate over time.

This calls for active analysis of the merits of structured products. We have commented on the complexity of structured products as early as 2005 (September 2005 blog). Since these complex instruments continue to sell well, then there is reason to believe that there are still investors out there who do not fully understand the inherent risks of these products.

SLCG has a dedicated website providing papers, notes and calculation tools on a variety of structured products. We have also written several papers on structured products that can be found in our research section here.

## Tuesday, October 12, 2010

### SLCG Research: Leveraged Municipal Bond Arbitrage

SLCG released today ‘Leveraged Municipal Bond Arbitrage: What Went Wrong ?’. Leveraged municipal bond arbitrage is a strategy employed by fixed income hedge funds. This strategy buys long term municipal bonds and sells or shorts long term Treasury bonds while hedging with interest rate swaps. The strategy would seek to profit from the difference in the rates it receives from the municipal bonds and the rates it pays on the Treasury bonds and interest rate swaps.

Brokers marketed hedge funds that employed this strategy as an alternative to traditional municipal bond funds and claimed that such a strategy offered higher returns with little to no additional risks. Prompted by substantial losses in multi-billion dollar fixed income hedge funds during the crises of 2008, we wrote a paper explaining what leveraged municipal bond arbitrage strategy was not, what it really was and its underlying risks.

We argue that, while brokers and hedge funds claimed that the higher yields in municipal bonds were a result of the excessive supply of municipal bonds pressing down prices and pushing up rates, the higher yields came from the embedded call option and the liquidity and credit risks of municipal bonds.

We conclude that leveraged municipal bond arbitrage was not an arbitrage, but a bet on short call options and interest rates. Furthermore, we conduct simulations to show that such a portfolio was much riskier than a traditional municipal bond portfolio.

## Tuesday, October 5, 2010

### SLCG Research: Auction Rate Securities

SLCG released today ‘Auction Rate Securities’.

Auction rate securities were first issued in the mid-1980s by corporations. Over the next two decades ARS were issued widely by institutions ranging from closed-end mutual funds, municipalities to student loan trusts. ARS were long-term floating rate securities whose coupon payments were determined at auctions that were typically held every 7 to 35 days. ARS were long-term securities with short-term floating rates.

Broker dealers marketed ARS as liquid, short-term cash equivalents. However, ARS auctions failed en masse in February 2008 and proved to be illiquid and unsellable in the short-term.

In this paper, we explain what ARS were, how they evolved, how their auctions worked and how they auctions failed.

ARS were typically subject to maximum rates, which is a ceiling on the rate received by ARS investors. When ARS investors wanted rates higher than the maximum rate, auctions began to face the risk of failing. Unbeknownst to investors, broker dealers, in an effort to prevent auctions from failing, intervened in auctions by buying up excess supply at maximum rates and, at times, by waiving maximum rates to induce demand. When broker dealers suddenly gave up intervening in February 2008, auctions failed en masse, leaving ARS investors with long-term illiquid securities.

We conclude that the ARS were not liquid short-term cash equivalents. We also conclude that the inherent flaw of maximum rates contributed to the mass failures and that investors were exposed to the strategic behavior of broker dealers during the period leading up to the mass failures.