Tuesday, May 31, 2011

FINRA Press Release: Non-Traded REITs

FINRA Charges David Lerner & Associates Over Sale of Non-traded Apple REITs
The Financial Industry Regulatory Authority (FINRA) issued a press release yesterday in which it announced that it had
filed a complaint against David Lerner & Associates, Inc. (DLA), of Syosset, NY, charging the firm with soliciting investors to purchase shares in Apple REIT Ten, a non-traded $2 billion Real Estate Investment Trust (REIT), without conducting a reasonable investigation to determine whether it was suitable for investors, and with providing misleading information on its website regarding Apple REIT Ten distributions.
The Statement of Complaint can be found here.

Real Estate Investment Trusts (REITs) are trusts that invest in real estate. Many investors think that REITs are similar to fixed income as they pay a yearly payment as is similar to a dividend payment, but they are not. They receive special tax treatment that allows them not to pay corporate income tax. In order to receive this special tax treatment REITs are required to distribute at least 90% of their income to their investors. This is a structure that is analogous to a mutual fund albeit it invests in real estate. REITs can be publicly traded or privately held. Public REITs need to file quarterly report with the SEC and trade on exchanges similarly to stocks. Private REITs are usually sold as private placements by an underwriter using a broker. Private placements are subject to less regulation, scrutiny, and disclosure than public ones. Moreover, private REITs are very illiquid.

Thursday, May 26, 2011

FINRA Investor Alert: Stock-Based Loan Programs

Stock-Based Loan Programs: What Investors Need to Know
The Financial Industry Regulatory Authority (FINRA) published an Investor Alert on the risks and rewards of non-recourse stock-based loans, loans which are given to borrowers who pledge fully paid securities as collateral to the lenders. This collateral is the only recourse the lenders have with which to reclaim the loans from the borrowers. The lender holds the securities during the period of the loan and returns them – with profits – at the end of the loan.

Investors should be aware of the risks associated with stock-based loans. Firstly, the interest rates are relatively high and so investors seeking to profit by being a borrower of the stock-based loan will only profit if the collateral security appreciates more than the loan plus interest. Secondly, there is a risk that the lender does not return the collateral to the investor at the end of the loan. Thirdly, an investor, without cash or other liquid investments at hand, should not invest the proceeds of the stock-based loan in long-term instruments, since the stock-based loan is usually short-term and so by the time the loan ends the investor must have cash or liquid investments ready at hand to pay back the loan. Other risks include tax risk (being taxed on the proceeds of the loan or the collateral security when you would otherwise not have to pay such taxes) or having your lender immediately selling your collateral security immediately after the loan takes place (and therefore you are robbed of any appreciation the security might experience during the term of the loan).

SLCG supports the dissemination of information that can inform and educate everyday investors of both old and new financial products. For a view of the work we do, please visit our dedicated website and read our research.

FINRA Press Release: Subprime Securitizations

FINRA Fines Credit Suisse Securities $4.5 Million and Merrill Lynch $3 Million for Misrepresentations Related to Subprime Securitizations

The Financial Industry Regulatory Authority (FINRA) issued a press release today announcing that
it has fined Credit Suisse Securities (USA) LLC $4.5 million, and Merrill Lynch $3 million for misrepresenting delinquency data and inadequate supervision in connection with the issuance of residential subprime mortgage securitizations (RMBS).
The settlement is detailed in the FINRA AWC No. 2008012808901 and the FINRA AWC No. 2008012808201.

Misrepresentations of this kind have happened before, such was the case with Deutsche Bank Securities, which was fined $7.5 million by FINRA back in July 2010 for negligent misrepresentations of mortgage delinquencies related to subprime mortgage backed securities.

A mortgage backed security (MBS) is a debt security whose cash flows come from, and are backed by, the principal and interest payments of borrowers on the mortgage loans. The pooling of mortgages into a debt security is called securitization and is performed by a trust. Mortgages are originated by public and private agencies, they are then securitized into MBS by a trust, and then the MBS is issued to public investors by the trust. MBS carry a variety of risks for investors, such as interest rate and prepayment risk (when the borrowers refinance to a new mortgage) and credit risk (of the borrower). When mortgage delinquencies increase the credit risk of the MBS obviously increases, this explains why brokerages that sell MBS have an incentive to cover up delinquencies.

SLCG has written a paper describing the market and history of CMOs (a type of MBS) in the wake of the collapse of Brookstreet Securities and two Bear Stearns hedge funds which held CMOs and suffered huge losses. Investors can use our dedicated website for other papers and notes.

Tuesday, May 10, 2011

SEC Press Release: Assigned Credit Ratings

SEC Seeks Public Comment to Assist in Study on Assigned Credit Ratings 

The Securities and Exchange Commission (SEC) issued a press release today announcing that it had requested
for public comment on the feasibility of a system in which a public or private utility or a self-regulatory organization would assign a nationally recognized statistical rating organization (NRSRO) to determine credit ratings for structured finance products.
The SEC’s effort is mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Structured finance products are securities with unconventional and complex payoff structures. They often have high fees, high transaction costs, and are priced well above their fair market price, see for example Henderson and Pearson (2011)

A proper and objective system of assigning credit ratings to structured products is critical for investors who cannot otherwise measure the overall risks of these products. One of the risks is credit risk – the risk that the issuer or borrower fails to make payments to the investor or lender. Structured products depend on the solvency of the issuer, as was very clear when Lehman Brothers collapsed. SLCG has written several papers on the topic including a paper that describes structured products after the collapse of Lehman Brothers.

Investors can use our dedicated website for other in-depth analyses of a variety of security products and markets.

Wednesday, May 4, 2011

SEC Press Release: Fraudulent Bidding Practices

SEC Charges UBS with Fraudulent Bidding Practices Involving Investment of Municipal Bond Proceeds

The Securities and Exchange Commission (SEC) issued a press release today announcing that it had 
charged UBS Financial Services Inc. (UBS) with fraudulently rigging at least 100 municipal bond reinvestment transactions in 36 states and generating millions of dollars in ill-gotten gains. To settle the SEC’s charges, UBS has agreed to pay $47.2 million that will be returned to the affected municipalities. UBS and its affiliates also agreed to pay $113 million to settle parallel cases brought by other federal and state authorities.
This is the SEC Complaint and the Litigation Release No. 21956.

Readers may remember a very similar SEC charge against the Bank of America Securities in December of last year. UBS was the bidding agent on behalf of the municipalities (and other parties) in the market for reinvestment products. According to the SEC, UBS rigged the bidding process. For example, UBS set up the bidding process such that it “illicitly won bids as a provider of reinvestment products” as well as bids for other providers when it was a bidding agent for municipalities. It also secretly paid bidding agents in the form of swap payments. By playing multiple roles in the competitive bidding process, UBS was able to effectively rig the transactions.

Municipal bonds are bonds issued by government entities at the city, county and state levels. Municipalities issue bonds to finance their projects for the public good. These bonds are called municipal bonds, and their rates may be fixed or floating. They are usually long term bonds. Municipalities usually use the proceeds of the bonds to purchase reinvestment products before using them for the municipalities’ intended purpose.

SLCG has written several papers relating to municipal bonds:
Investors may find in our dedicated website many other interesting papers and notes.

SLCG Research: Oppenheimer Champion Income Fund

SLCG released today ‘Oppenheimer Champion Income Fund’.

Oppenheimer’s Champion Income Fund (the Fund) was an open-end mutual fund that invested in high-yield bonds. It lost 80% in the second half of 2008, the highest loss for a mutual fund in Morningstar’s high-yield bond fund category.

In this paper, we look at the portfolio management rules and decisions of the Fund in the context of what was happening in the markets. Leverage using debt to fund further investments was prohibited by the Fund. To get around the restriction, the Fund invested heavily in credit default swaps (CDS) and total return swaps (TRS) as an alternative way to leverage its investments in corporate debt and asset-backed securities. However, CDS and TRS became increasingly risky during late-2007 and early-2008. While other high-yield bond funds reduced their holdings in CDS and TRS, the Fund increased such holdings. The Fund also increased its holdings of commercial mortgage-backed securities and other mortgage-backed securities just when these markets were collapsing. These decisions directly contributed to the huge losses of the Fund. Furthermore, we find that the Fund failed to adequately disclose the risk of its holdings to its investors.