Sparer Law Blog

Muni Bond Funds Loaded With Unrated Bonds A "Red Flag"

2011-03-16T16:47:00.000-07:00

Municipal bond funds are often thought to be safe investments, but be careful, especially with funds stuffed full of unrated bonds:

Nuveen Investments LLC's High Yield Municipal Bond Fund has 46.9% in non-rated bonds. Waddell & Reed's Municipal High Income Fund and the firm's Ivy Municipal High Income Fund have 44.9% and 39.15%, respectively, in non-rated bonds. OppenheimerFunds' Rochester National Municipal Fund has 43% in non-rated bonds, and its Oppenheimer AMT-Free Municipals Fund has 38%.

“I would say that anything with more than 20% in non-rated bonds requires absolute confidence in the management team,” said Eric Jacobson, director of fixed-income research at Morningstar. “Anything above 40% is a red flag.”

So, what's the problem with having so much of a fund's assets tied up in unrated bonds?:

Non-rated bonds tend to be small in size and thinly traded. The average size of these issuers is $21 million, according to Municipal Market Advisers. Given the continuing headline risk in the municipal bond market, funds with such large allocations to non-rated bonds risk having to meet massive redemptions and getting stuck with having to sell these less liquid, non-rated bonds at lower prices, Mr. Jacobson said.

Another trouble with these bonds is that since they tend to be thinly traded, it can often be difficult to price them, experts said. This is a risk with all municipal bonds but even more so for non-rated bonds, said Matt Fabian, managing director at MMA.

“When you have uncertainty about what the bonds are worth and managers reporting the value on the bonds, you need to make sure they aren't exaggerating the value of the bonds,” Mr. Fabian said.

According to Investment News, here are the top-10 muni funds with the highest percentage of unrated bonds:

Invesco High Income Municipal A: 64.3%
Invesco Van Kampen High Yld Municipal A: 61.3%
Nuveen High Yield Municipal Bond A: 46.9%
Waddell & Reed Muni Hi-Inc A: 44.9%
Oppenheimer Rochester National Muni A: 43.0%
Pioneer High Income Municipal A: 41.1%
Lord Abbett High Yield Municipal Bond A: 40.2%
Ivy Municipal High Income I: 39.2%
Oppenheimer AMT-Free Municipals A: 38.0%
Federated Municipal High Yield Adv F: 35.3%

It is important to note that most if not all of these funds are high yield funds. Oppenheimer's California Municipal Bond Fund, which purported to be a more conservative, capital preservation bond fund, had over 60% of its assets invested in unrated bonds as of December 31, 2008, according to Lipper.

That's one big reason that when the financial crisis hit in 2008, Oppenheimer's California Municipal Bond Fund lost over 46% of its NAV while the average loss among funds in the same Lipper Classification only lost 11% over the same time period.

At the very least, Oppenheimer should have disclosed the enormous risks that it was taking with investors' money.

Misuse of leveraged and inverse ETFs by financial advisors

2011-03-09T14:31:00.000-08:00

Registered Rep reports that financial advisors have been misusing complex and highly risky leveraged ETFs for their unsophisticated clients:

"The problem is, while inverse/leveraged funds are appropriate for some sophisticated investors in small doses, they have been sold more aggressively in some cases. Inverse/leveraged funds are best for institutional or high-net-worth investors who want to hedge exposure and protect against short-term market issues, says David Kathman, senior mutual fund analyst with Morningstar. Allocations should be no more than about 5 percent, he added. 'Even then, I would hope they would be cautious because these types of things can turn on a dime.'”

Registered Rep notes however, that advisors have been putting up to 30% of unsophisticated clients' assets in these unsuitable vehicles. The article warns that people should "[e]xpect a wave of claims this year against financial advisors and broker/dealers who recommended certain Direxion, Rydex and ProFunds leveraged and inverse funds, last year's worst performing mutual funds, say securities attorneys."

SEC Investigating Municipal Bond Funds

2011-03-08T15:02:00.000-08:00

According to the Bond Buyer, the SEC is investigating municipal bond funds such as Oppenheimer's California Municipal Bond Fund, which is the subject of a class action lawsuit lead by Sparer Law Group. It appears that the SEC is focusing on the same issues identified in the Oppenheimer lawsuit:

"The commission’s examiners want to know about fund holdings and to what extent they own certain debt, such as tender-option bonds and unrated securities. They want details on fund-owned munis that have defaulted. They also are asking the funds how they conduct credit analysis and how they determine the values of the municipal securities they hold, sources said."

The overlap in issues between the SEC investigation and the Oppenheimer class actions is not a coincidence. According to the author, the investigation "may have been prompted by the ongoing litigation between shareholders in seven muni funds managed by OppenheimerFunds that is pending in a federal court in Denver."

Bondholders Sue Banks to Recoup Losses on Mortgage Portfolios

2010-11-16T09:58:00.000-08:00

In a letter written Monday, October 18, 2010, a group of institutional bond investors raised objections to the handling of 115 bond deals issued by affiliates of Countrywide Financial Corp., acquired by Bank of America Corp. in 2008. See Wall Street Journal article here. The group of institutional investors is stepping up efforts to recoup losses on soured mortgage portfolios amid concern about sloppy mortgage servicing and underwriting practices.

The group, which includes mutual-fund managers, government-related entities, insurance companies and investment partnerships, is seeking to have loans that didn't meet underwriting requirements repurchased and to be compensated for losses due to inadequate mortgage servicing.

The article notes the fact that the time to pursue some of these claims is running out. Under New York contract law, investors generally have six years from the time of a securitization to put back loans that violate representations and warranties.

Sparer Law Group continues to investigate the underwriting and mortgage servicing practices of the banks that created these mortgage pools. If you are an investor and have questions about them, please contact the firm at 415-217-7300 or info@sparerlaw.com.

About the firm:

Founded in 2003, Sparer Law Group built its reputation protecting investor rights and recovering investment losses for individuals and institutions through both individual and collective actions. The firm specializes in cases involving complex securities products including derivatives, restricted stock, hedge fund and private equity investments. In 2009, Sparer Law Group was appointed lead counsel in the consolidated securities class action against the Oppenheimer California Municipal Fund, which lost nearly $1 billion of net asset value in 2008.

FINRA Issues Investor Alert Regarding Reverse Convertibles

2010-06-22T10:40:00.000-07:00

FINRA has issued a warning on its website to investors of Reverse Exchangeable Securities ("Reverse Convertibles").

Although often described as debt instruments, Reverse Convertibles are debt obligations of the issuer that are tied to the performance of an unrelated security or basket of securities. The Alert describes Reverse Convertibles as far more complex than a traditional bond and involve elements of options trading. In addition, Reverse Convertibles expose investors not only to risks traditionally associated with bonds and other fixed income products—such as the risk of issuer default and inflation risk—but also to the additional risks of the unrelated assets, which are often stocks.

FINRA issued the alert to inform investors of the features and risks of reverse convertibles that can be difficult for individual investors and investment professionals alike to evaluate. According to FINRA, if investors are considering purchasing Reverse Convertibles, it is critical that they look beyond the high coupon rate and focus on the risks of the underlying asset. FINRA warns ivnestors that even if the issuer of the reverse convertible is able to meet its obligations on the note—and even if the yield keeps pace with or surpasses inflation—investors could wind up, when the note matures, with shares of a depreciated—or even worthless—asset. Click here for the Full Investor Alert.

If you have suffered losses in Reverse Convertibles and would like more information, or would like to consult with an attorney on a confidential basis, contact SLG at 415-217-7300 or fill out our contact form.

SEC proposes new disclosures for target-date funds

2010-06-16T14:32:00.000-07:00

On Wednesday June 16, 2010, Federal regulators proposed new disclosure rules for target-date retirement funds that would require sponsors to spell out how they are investing the money and to warn about risks.
Click here for entire article.

Under the SEC proposal, target-date funds' marketing materials would have to include a prominent table, chart or graph showing the allocations among the various assets over the life of the fund. A statement would have to explain that the asset allocation changes over time, and tell prospective investors that they should consider their financial situation and tolerance for risk before going into a fund.

Target-date funds came under criticism during the market meltdown of 2008 and in its aftermath. Among 31 funds with a 2010 target date, the average loss in 2008 was nearly 25 percent.

Before the vote on the proposed rules, SEC Chairman Mary Schapiro stated: "It's clear that investors need more information than just the date in a fund's name."

Target Date Funds Can Be "Way Off Target"

2010-01-14T09:11:00.000-08:00

Tom Brakke, CFA, offers new criticism today on Morningstar of Target-Date Mutual Funds, despite this investment vehicle's reputation as one of the hottest investment products of the last decade.

According to Brakke, many target date funds were structured based upon questionable assumptions about asset classes and how they perform over time. "Historical returns, the variability of those returns, and the correlations among the returns of different types of assets were used in asset allocation models as if they were facts of nature." Brakke says many target date funds with a reference date of 2010 have received much attention, "since many who held the funds on the verge of retirement saw large losses in their account balances during 2008 (with some drops exceeding 30%)." Click here for the entire article. (Subscription may be required).

In Brakke's opinion the main flaw is that deciding that someone should have X% in equities and other risky assets without regard to the valuation of those assets ignores an important relationship: The probability that stocks will perform worse than their historical average return increases as valuations rise.

Merrill's "Penalty Box"

2009-03-03T09:58:00.000-08:00

Barry Ritholtz of the Big Picture has the interesting story of two brokers who run managed accounts at a large firm that "[r]hymes with Schmerrill." It should be a warning to all investors--brokerages compensate their brokers for investing your money, not for saving your money by pulling it out of failing investments. In fact, brokers who saved their clients' money by putting them in cash are being punished.

These two gents run a few $100 million dollars in managed accounts. They are mostly stock jockeys, but they have a smattering of bonds as well. Their assets are spread out amongst stocks they selected, in house managers, and other mangers on their firm’s platform. Typically, the clients are charged 1.0-1.25% on their assets. Various products (I hate that word) will pay the broker more or less depending upon the fund manager’s arrangements with the house.

As is typical of brokers with this size asset base and seniority, their payout was about ~43%.

Let’s do some quick math before we get to the heart of the conflict: On $300 million in assets, let’s call it $3.3 million dollars in gross revenue to the firm. That’s about $1.4 million to them, from which they pay a few sales assistants, T&E, etc. Thus, they each should be making about half million dollars annually before Uncle Sam takes his.

Here’s where things get interesting: Early in 2008, they moved aggressively into cash. (Obviously they are TBP readers). For most of the year, they run about 20% bonds, plus 5% percent stocks (some client would not sell). All told, about 75% of their asset base is in money market funds, which pays out essentially nothing to the broker — but preserves the clients investments. Late in the year, they put a toe back in the water.

Overall, the clients do very well. In a year where the markets are practically cut in half, their clients lose about 10%. The investors are ecstatic, and while the two brokers annual compensation was schmeissed — they went from over $3 million gross to under $1 million — they have happy, referral making clients to rebuild their business upon. Its a short term income hit that should generate gains over the long term. And, they got there by doing the right thing.

Now, that drop in income alone raises conflict issues. I tell clients who ask why they are paying 1% to sit in Cash that they are not — they are paying 1% to not be losing 45% in equities, and to have us tell them when to go back into stocks. We think that’s worth 1%, and if you disagree, well talk to your friends who have seen their investments destroyed.

Here’s where things get completely misaligned. When 2009 rolls around, their manager calls them into his office, and says: “Bad news, boys. Your revenues dropped so much last year you are in the Penalty Box. As per your contract, your payout for this year is 30%.”

Sparer Law Group Files Class Action Against Oppenheimer Bond Fund

2009-02-10T18:22:00.000-08:00

The Sparer Law Group has filed the first class action lawsuit on behalf of investors who purchased the Oppenheimer California Municipal Fund (Symbols: OPCAX, OCABX, OCACX) between September 27, 2006 and November 28, 2008. The case was filed on February 4, 2009 in the United States District Court for the Northern District of California, case number C 09-00567 SI. See our press release here.

The lawsuit alleges that the Fund's Registration Statements and Prospectuses misled investors about the Fund's investment objectives and underlying risk by describing the Fund as seeking current income "consistent with preservation of capital." The Fund lost over 41% of its net asset value ("NAV") in 2008. By comparison, the average loss for funds within the same Lipper peer group over this period was only 11.5%.

"The promise that a municipal bond fund follows a strategy designed to preserve capital cannot be just a sales pitch. It has to be reflected in an objective investment approach," said Alan W. Sparer, lead counsel. "Investors put their 'safe' money and retirement savings in muni bonds. These funds are not the place for speculative strategies or junk bond investments."

The lawsuit alleges that the Oppenheimer California Municipal Fund policies and operations ignored the preservation of capital objective by concentrating 78% of its assets in bonds rated at the lowest investment grade or below, and concentrating 60% in bonds that were not rated by any independent rating agency. In addition, 33% of the Fund's investments were placed in Dirt Bonds, which are based on contracts for land developments that have not been built yet and were especially vulnerable to the recent declines in California's real estate market.

In addition, the lawsuit alleges that Oppenheimer failed to disclose that, because of the Fund's overconcentration in lower rated bonds and bonds that had not been rated by any independent agency, there was a significant risk that more than 25% of its assets were in junk bonds, a violation of the Fund's fundamental investment policy.

The NAV of the Oppenheimer California Municipal Fund decreased by more than $1.1 billion in 2008.

A copy of the complaint is available here.

Investors who lost money in the Oppenheimer bond funds should contact the Sparer Law Group to investigate potential avenues for recovery.

Morningstar Flunks Oppenheimer Bond Fund

2009-02-10T18:18:00.000-08:00

Morningstar gives Oppenheimer an 'F' for failing to disclose the additional risks it had taken on in its bond funds:

""The managers bought complex, off-balance-sheet swap contracts that created a leveraging effect on the funds," Gogerty said. The managers made no attempt to tell investors that the funds were taking on additional risk, he said."

The article states that "Oppenheimer failed investors by not telling them that two of its bond funds had recently taken on extra risk." The end result was that "Oppenheimer's normally stable Champion Income and Core Bond funds saw huge losses in 2008, dropping 78% and 36% respectively."

Oregon Investigating Oppenheimer Bond Funds

2009-02-06T16:11:00.000-08:00

Officials demand financial data from OppenheimerFunds:

Oregon State officials are investigating Oppenheimer, which managed Oregon's College Savings Network:

"The bond funds in question contributed to exorbitant losses in the network's conservative portfolios. OppenheimerFunds' Core Bond fund declined about 35 percent last year. The short-term government fund lost 6 percent last year. By comparison, a benchmark measure of its peers -- Barclays Capital U.S. 1-3 Year Government Bond Index -- gained 6.7 percent."

What Feeder Fund Managers Suspected About Madoff

2009-01-27T10:13:00.000-08:00

It turns out that many of Madoff's feeder fund managers--the people who brought much of the money from individual investors into Madoff's Ponzi scheme--had long suspected that Madoff was engaging in illegal activity. According to Bloomberg, they just assumed that they were benefiting from the illegal activity and not being victimized by it. They thought that Madoff was using his position to "front-run" trades by his clients.

The purported mission of such feeder funds was to vet hedge funds for wealthy clients. Instead, the line between victim and perpetrator was blurred. Middlemen like Littaye funneled billions of dollars to Madoff, even, in some cases, when they suspected he was engaged in questionable trading practices. In return, they reaped hundreds of millions of dollars in client fees.

Lower Returns

Wolfer says he heard of traders trying to replicate the split-strike conversion strategy Madoff told investors he used -- buying shares of large U.S. companies and entering into options contracts to limit the risk -- and getting far lower returns. He also says he heard Littaye and other middlemen talk about how Madoff may have used the knowledge he gained from his market- making firm, New York-based Bernard L. Madoff Investment Securities LLC, to get in and out of stocks ahead of market swings.

That’s front-running, a term usually applied to brokers’ trading for their own account -- and profit -- ahead of clients.

It’s also applicable to Madoff’s purported practice, says Peter Henning, a law professor at Wayne State University in Detroit and a former federal prosecutor.

“Front-running isn’t who’s getting the benefit; it’s who’s paying the price,” says Henning, noting that Madoff’s market- making customers expected the firm to obtain the best price available when buying or selling stocks. Instead, their interests were apparently subordinated to those of Madoff’s investment clients.

Front-Running

While front-running is illegal, it didn’t horrify Madoff’s champions.

“They were convinced that the risk was only that the Securities and Exchange Commission would do something about breaches of the Chinese wall in the Madoff organization,” Wolfer says. In the worst case, he says, “what could be expected was that at a certain point the SEC could say stop.”

It was obvious to anyone who looked that something fishy was going on with Madoff's trades:

"An executive at a fund of funds that invested in Kingate says he once examined Madoff’s trading records to see whether they reflected the stocks’ publicly reported activity. He found Madoff consistently bought stocks at their lows and sold them at their highs.

The executive, who wouldn’t be identified, says he reported back to his boss that he thought Madoff was front-running his clients. He says the boss’s reply was 'Yeah, so what? That’s his edge.'"

Why did the manager's of these feeder funds turn a blind eye to what appeared to be blatantly illegal activity and take such risks with their clients' money? Answer, they were raking in huge fees in return for being Madoff's willing accomplices:

"If a fund charged its clients 1 percent of the assets under management and 20 percent of the gains, as the largest one did, that translated into $41 million in annual fees.

Assuming Madoff didn’t do any investing on behalf of his clients, as investigators now suspect, the feeder funds were, in effect, being paid out of principal, which would have been depleted after 15 years.

In other words, much of the money invested in Madoff through feeder funds wound up in the pockets of fund managers."

Barry Ritholtz of the Big Picture is right in part when he says that the Trustee should "confiscate the Funds of Fund managers’ houses, cars, watches, jets and boat — as the illegal proceeds of a crime. Auction ‘em off, put the proceeds into a fund for the scam’s victims."

But the investors don't have to wait for the Trustee to act, and many are not:

"Chais’s Brighton Co.; Bank Medici, which was taken over by Austrian regulators; Fairfield Greenwich; Merkin’s funds; and Tremont have all been sued by investors claiming the firms should have known better than to invest with Madoff."

Target Date Mutual Funds Riskier Than Thought

2009-01-12T17:43:00.000-08:00

Poor performance this year of Target Date Mutual Funds has left many investors asking questions about their holdings. Target date funds - also known as a lifecycle or age-based funds - are designed to take decision making out of an investor's hands when it comes to figuring out how to invest for retirement. The idea is you simply put your money into a single fund linked to the approximate year in which you plan to retire. Fund companies say they'll do the rest. The funds are supposed become more conservative as the target date approaches. But many with a target date of 2010 (less than a year away) have been reeling in the market with losses ranging from 15 percent to more than 40 percent to date, according to Barbara Whelehan. Click here for full article. Some funds may have had exposure to high risk bond holdings, CMBS, Swaps and toxic derivatives. According to SmartMoney, Target-date funds are trickier to evaluate than standard mutual funds, carry unique risks, and their lack of transparency is a big problem.

Investors holding funds with a date of 2010 or 2015 with large losses should feel free to contact Sparer Law Group to discuss their investment holdings.

Did Municipalities Overpay For Swaps and Swaptions?

2009-01-09T10:46:00.000-08:00

The S.E.C., the Justice Department, and various states' Attorneys General are investigating what may be "one of the longest-running, most economically pervasive antitrust conspiracies ever to be uncovered in the U.S."

Three federal agencies and a loose consortium of state attorneys general have for several years been gathering evidence of what appears to be collusion among the banks and other companies that have helped state and local governments take approximately $400 billion worth of municipal notes and bonds to market each year.

E-mail messages, taped phone conversations and other court documents suggest that companies did not engage in open competition for this lucrative business, but secretly divided it among themselves, imposing layers of excess cost on local governments, violating the federal rules for tax-exempt bonds and making questionable payments and campaign contributions to local officials who could steer them business. In some cases, they created exotic financial structures that blew up.

People with knowledge of the evidence say investigators are not just looking at a few bad apples, but also at the way an entire market has operated for years (emphasis added).

Banks have exacerbated the damage to many municipalities by selling them unnecessary interest rate swaps that have driven some cities and counties to the verge of bankruptcy:

The use of derivatives in connection with municipal bonds has grown rapidly in the last five years. The packages are presented as money-savers to the municipalities, which may want to protect themselves against interest rate changes. But over the last year, as turmoil spread through the credit markets, some of the derivatives have blown up, leaving local governments stuck with unexpected costs.

That happened in Alabama, where Jefferson County linked an extraordinary number of derivatives, called interest-rate swaps, to its bonds, in some cases with the help of CDR Financial. Despite publicized concerns about whether improper payments to certain officials were behind the swaps, the county insisted the swaps were saving money. Last year, the derivatives failed, leaving the county with vast bills. Jefferson County is now at risk of declaring what would be the biggest governmental bankruptcy in United States history.

Even in places where the bonds and derivatives are performing as expected, irate government officials are finding they may have overpaid for various services and have inadvertently broken federal tax rules. Again and again, proceeds from tax-exempt bonds appear to have improperly generated investment income for banks and insurers.

Among the governments that have sued these financial firms are the cities of Chicago and Baltimore; Oakland and Fresno, Calif.; the state of Mississippi; and a number of counties, school districts and at least one water and sewer district. The lawsuits were consolidated in November, in Federal District Court for the Southern District of New York (emphasis added).

Municipalities should examine prior bond offerings and interest rate swap purchases very carefully to see if they have been victimized by this scam.

Constant-Proportion Debt Obligations

2008-12-31T10:08:00.000-08:00

Noah Millman, a blogger and Wall Street banker working in structured finance, has posted his eye-of-the-storm view of how banks and ratings agencies worked together to create products that self-evidently never merited their AAA ratings. He provides as an example the constant-proportion debt obligation, or CPDO, which Millman describes as "an ingenious little fraud of a product."

Here’s how it worked.

Some clever structurer noticed that, historically, investment-grade companies don’t default very often. Rather, they deteriorate for a while first, get downgraded to junk status, and eventually they default. That’s why the short-term ratings for relatively low-rated investment-grade companies may be reasonably high: even BBB companies are generally good for the next 90 days; if they weren’t, they wouldn’t be rated BBB. And this suggested the possibility of a trading strategy.

What if you bought a portfolio of investment-grade corporate debt and, every six months, purged it of the bonds that were downgraded to junk, replacing these with new investment-grade bonds. Obviously, you’d expect the downgraded bonds to underperform the remainder of the pool, so you’d have losses you need to make up, so assume you also sell out of a handful of bonds that have done well, and replace these with higher-yielding bonds that are still investment-grade, thus keeping your yield relatively constant. You’d still expect some losses if you wanted to keep your average rating relatively constant, though. So you need some excess yield to make up for these losses.

You find that yield by leveraging the portfolio. After all, it’s an investment-grade portfolio, very unlikely to default in the short term. You can borrow very cheaply short-term, invest in longer-term bonds, and earn the spread differential. If the bonds go against you, that’s OK, because you’re going to hold them to maturity and you’ll always be able to roll your short-term borrowing. And, if you can get a high enough degree of leverage, the excess in current yield from the differential between where you borrow and the yield on your portfolio should more than pay for the cost of rolling out of your losers every six months. And if you do that successfully, you’ve got a trading strategy that never loses principal, but has a surprisingly high expected yield. Sound good?

Well, it sounded great to the ratings agencies, who blessed this strategy by giving it a AAA rating.

How did they justify that AAA rating? By looking at the historic cost of rolling credit derivatives on indices of investment-grade corporate issuers, which generally have a high-BBB rating. These had been around for about three years when the first CPDOs were rated, and the roll had never cost more than 3 basis points. Factoring in that cost, at a leverage of 15-to-1, and using historic 6-month default rates for the portfolio (since the index would be rolled every six months), the proposed trading strategy would never lose money. Hence a AAA rating.

Let me reiterate that, just to drive the point home. The ratings agencies said: you can take a BBB-rated index, leverage it 15-to-1, and follow an entirely automatic trading strategy (no trader discretion, no forecasting of defaults or anything, just a formula-driven adjustment to the leverage ratio and an automatic roll of the index), and the result is rated AAA.

Needless to say, this worked out really well for all concerned. But that’s not really the point. The point is: the notion that you could grant a AAA based on a trading strategy for which there was at best three-years of data (three years that encompassed not a single recession, I’ll note) is mind-boggling. And, worse than that, nobody at the agencies apparently stood up and said, “wait a second: how can you turn a BBB into a AAA by leveraging it 15-to-1? That’s impossible!” Which, of course, it is.

I want to be very clear about something: we’re not talking about a CDO where the AAA investor is providing leverage, and there are subordinate investors below who bear the first risks of loss. This was a trading strategy; the investor in the AAA CPDO had first-loss risk with respect to a BBB portfolio. The trading strategy was just supposed to generate enough returns to create “virtual” subordination to justify the AAA.

When I first heard about this product, I thought: whichever agencies rated this thing have lost their minds. When people asked me whether it made sense as an investment, I said: it’s an outright fraud. You’re practically guaranteed to lose money. I never bought or sold one of these things myself, and neither did anyone else in our group. But the existence of such a ridiculous product should have been a wake-up call about just how divorced from reality the agencies were. And if they were out to lunch on something as straightforwardly absurd as the CPDO, how out to lunch were they on other products, ones that were far more significant to the markets and the economy, where the absurdity of their assumptions was less-obvious? (emphasis added).

These products were offered by, among others, ABN-AMRO. If you invested money in a CPDO, you may want to consider whether the true risks of this product was disclosed to you.

Europe’s Toxic Debt Imperils Wisconsin School District’s Finances

2008-11-06T13:31:00.000-08:00

According to Anne Szustek, the Whitefish Bay School Board is now filing a lawsuit alleging misrepresentation against Royal Bank of Canada and Stifel Nicolaus, the companies that sold them Synthetic CDOs.

David W. Noack, an investment banker who had been giving guidance to school boards in Wisconsin for some 20 years, suggested that the Whitefish Bay school board should buy into a series of European investments that he said could only mean steep returns.

The Whitefish Bay School District and four other local school systems spent $35 million and borrowed an additional $165 million from Irish bank Depfa to buy up synthetic collateralized debt obligations, or synthetic CDOs. Synthetic CDOs are a form of insurance that guarantees corporate bonds. Should a company default on its debt, the synthetic CDO steps in to cover that loss.

The only way it would fail? “There would need to be 15 Enrons,” Noack said. It turns out that $200 million of the districts’ pooled funds were used to back $20 billion in corporate bonds. The synthetic CDOs turned out to have been toxic, and the money the Whitefish Bay School District put up is now going toward covering that debt.

Both companies being sued maintain that the school board signed documents knowing what it was getting into. Click here for full article.

New York City Sues Countrywide's Underwriters for Allegedly Helping the Home Lender Defraud Investors.

2008-01-25T15:06:00.000-08:00

New York's city and state comptrollers and their pension funds have sued Goldman Sachs Group Inc., Citigroup Inc., JPMorgan Chase & Co. and 23 more underwriters of Countrywide Financial Corp. for allegedly helping the home lender defraud investors.

The state and city pension funds' combined losses due to Countrywide's declining stock price were as much as $100 million, according to City Comptroller William Thompson Jr.

``Investors lost millions and New Yorkers lost their homes,'' New York State Comptroller Thomas DiNapoli said in a statement. ``We need to recover the pension fund's losses and find a way to help all those families.''

Click here for full article.

Merrill Lynch & Co. probed in connection with sales of CDOs to the city of Springfield

2008-01-04T15:11:00.000-08:00

Merrill Lynch & Co. was subpoenaed by Massachusetts regulators after the value of collateralized debt obligations the brokerage firm sold to the city of Springfield plunged 91 percent because of losses tied to subprime mortgages.

Click here for the full article.

``There are a whole range of concerns, including how the investments were presented to the city of Springfield and whether these were inappropriate investments for a city,'' Secretary of State William Galvin said. ``We don't want to pre-judge but just want to assess the information.''

The Springfield finance board said it ``believes that Merrill Lynch can and should be held fully accountable for any potential losses.''

Barclays sues Bear Stearns over CDO hedge funds

2007-12-19T14:55:00.000-08:00

Barclays Bank Plc (BARC.L) on Wednesday accused Bear Stearns Co Inc (BSC.N) of using two hedge funds that collapsed last summer as places to unload troubled assets.

Clickhere for full article.

The London-based bank's allegations appear in a lawsuit filed in U.S. Court for the Southern District of New York in Manhattan.

Barclays described the collapse of two Bear Stearns-run hedge funds as one of the most shocking in the last decade.

"Bear Stearns ... used the enhanced fund as a place to unload excessively risky or troubled assets that could not be sold to other investors at the prices paid by the enhanced fund," Barclays said in its complaint.

At the end of May, for example, Bear Stearns Asset Management had the enhanced fund buy about $500 million of the riskiest classes of securities in a deal that it managed, Barclays' complaint says.

"BSAM did so despite the fact that investment restrictions it had promised Barclays did not permit those securities to be held in the fund," the complaint said.

(Reporting by Tim McLaughlin; Editing by Jeffrey Benkoe, Leslie Gevirtz)

The Subprime Meltdown: For CDO Investors There is a Remedy

2007-11-14T11:32:00.000-08:00

Click here for full article.

While each CDO is unique, certain tendencies in the formation of both the rated and unrated tranches have emerged. By 2006, data was available showing a dramatic increase in the risk of subprime mortgages comprising many pools of CDO collateral. The quality of loans, the rate of default, the loan-to-value ratios, and the level of documentation were known to be in decline.

CDO issuers could have taken defensive steps, including rejecting risky loans, adding more loans to cushion against loss, and fully and timely disclosing declining creditworthiness of their CDOs. Rating agencies also could have demanded changes. But, as the market for CDOs expanded and financial institutions discovered that they could pass off mortgage risk to investors, underwriting standards collapsed to irresponsible levels--with the full knowledge of the rating agencies. Both groups reaped enormous profits.

Historically, Wall Street has responded to criticism of product sales with two powerful arguments, neither of which applies to mortgage-backed CDOs.

The first defense is that independent ratings agencies such as S&P, Moody's, and Fitch evaluated and blessed each CDO before it was sold. But in the past few years, rating agencies were paid only on condition that the CDO went to market, received large continuing fees for periodically re-evaluating the products, and also collaborated with managers in structuring many CDO investments. In short, the rating agencies were not independent, and now many 2006 and 2007 CDOs are facing defaults and downgrades, effectively an acknowledgment that the original ratings issued only months earlier were deficient.

The second defense typically offered is that CDOs were purchased by institutions and sophisticated individuals with access to their own financial professionals, who were fully capable of evaluating the risks. This isn't rocket science. Caveat emptor.

But structured investment vehicles are rocket science, and not just any institutional investor or high net worth individual has the capacity to engage the army of math Ph.D.s and MBAs that Wall Street employs to create and value these products.

In 2006, the Law Offices of Alan W. Sparer won an award of $5.8 million against Deutsche Bank for its role in connection with the sale of CLOs and CDOs.

Florida Agency Holds $2.2 Billion of Debt Cut to Junk Status

2007-11-14T11:17:00.000-08:00

November 14, 2007 - Bloomberg reports that the Florida agency that manages about $50 billion of short-term investments for the state, school districts and local governments holds $2.2 billion of debt that was cut below investment grade. Florida rules require the state's short-term investments to only be top-rated, liquid securities, so taxpayer funds aren't placed at risk.

Former SEC Chairman weigh in...

``Investment of public money needs to be carefully conducted and thoroughly researched,'' said Harvey Pitt, former chairman of the U.S. Securities and Exchange Commission. ``This is not the place for seat-of-the-pants judgments. It requires a lot more than jumping on the latest investment du jour to improve your results.''

Florida isn't the only government whose short-term investments have been affected by rising mortgage defaults in the U.S. and investors' diminished appetite for the securities tied to them.

``I think there are other communities that are going to follow, probably a lot of them,'' former U.S. Securities and Exchange Commission Chairman Arthur Levitt said today in an interview.

``I think we've got to pay more attention,'' Levitt said. ``They're playing with pensioners' money. That's serious. That's more serious than a brokerage firm or a bank losing money on a bad bet. We're talking about pension losses, and I think the fact that this is spreading is something that we've got to watch very, very carefully.''

According to the report, nearly 1,000 school districts, cities and counties invested in the fund, and have now been informed of its downgraded debt. Click here for full article.

"Breaking the buck?" Money Market Funds are Spending Millions to Ensure a Dollar is Still Worth a Dollar

2007-11-14T10:13:00.000-08:00

Bank of America announced Tuesday, November 13, 2007 that it planned to set aside $600 million to cover potential losses in tis money market funds and an institutional cash management fund. This is the largest step by a financial institution to ensure that its money funds aren't forced to reduce the value of their shares. Click here for the full article.

"Money funds have long appealed to people as super-safe investments. And they've kept their share prices fixed at $1 a share. But unlike banks' money market deposit accounts, money funds are not federally insured. The crisis in subprime mortgages has jolted the market for the short-term securities that money funds invest in. Even so, assets in money funds recently hit a record $3 trillion.

...

Several other financial institutions have also bolstered their money funds:

- SEI, an insitutional money manager in Oaks, Pa., has set aside $129 million to support two of its money funds.

- Legg Mason, a Baltimore money management firm, has set up a $238 million line of credit for two money funds. It also invested $100 million to buoy an offshore money fund.

- SunTrust (STI) has received SEC permission to set up credit lines for two money funds.

ANTITRUST INVESTIGATION SHEDS LIGHT ON ACTIONS OF RATING AGENCIES

2007-11-11T09:47:00.000-08:00

A report in the week-end edition of the Wall Street Journal dated Saturday/Sunday, October 27 - 28, 2007--that Moody’s, Standard & Poor and Fitch are being investigated in connection with potential antitrust violations--sheds light on potential abuses that may account for the recent precipitous round of rating downgrades by these same agencies. According to the REPORT, the Connecticut Attorney General’s office has issued subpoenas to the three rating agencies in connection with the alleged practice of “unsolicited ratings, “notching,” and “exclusive contracts.” CLICK HERE FOR FULL ARTICLE.

"There are allegatuions that some raters conduct an unsolicited rating and then demand the issuer pay for it or face a possible poor rating," the attorney general said. Notching is when raters allegedly threaten to downgrade an issuer's debt unless they get a contract to rate the issuer's entire debt pool, even if parts already have been assessed by another agency.
Exclusive contracts give issuers discounts for having all their debt rated by a single agency. "Such agreements may hinder competition by locking out other debt raters," the attorney general said.

These practices, if they did occur, are designed to do anything but ensure accurate classification of residential mortgage backed securities, such as collateralized debt obligations (CDOs). Whether the alleged practices violate antitrust laws or not, they could and would have resulted in inaccurate and misleading ratings upon which investors relied in purchasing CDOs, which have been sold in the billions. Such practices would also explain why many such products have been substantially downgraded only a few months after receiving a favorable rating.

In fact, the same Wall Street Journal edition carries a report with the headline “CDO Ratings Are Whacked By Moody’s: AAA to Junk in a Day Raises More Questions About Credit Arbiters.” The Journal announces $8.3 billion of DOWNGRADES by Moody’s primarily in connection with mortgage back securities. In one instance a $843 million CDO slice, known as a tranche, and having a AAA rating (which means first call on the income stream of a mortgage loan pool) was downgraded “10 notches to a junk rating of Ba1.” Another $229 million AAA tranche was cut “14 notches to a junk rating of B2.”
CLICK HERE FOR FULL ARTICLE.

These kinds of changes can lead to a distress sale by purchasers, such as insurance companies, pension funds, and hospital or educational non-profits, who are required to hold rated investments by regulatory mandate or by the terms of their established investment policy.

MetroPCS files $134 million suit against Merrill for CDO losses

2007-10-29T16:12:00.000-07:00

Merrill Lynch & Co. is being sued by Metro PCS in Dallas County, Texas, over a $134 million investment made this spring in CDOs that Merrill underwrote between 2003 and 2006. This according to a WSJ artcile written last week in the wake of Merrill's giant write-down of $8.4 Billion of CDOs. Click here for the full artcile. The article profiles Christopher Ricciardi, a former Merrill hand who pioneered the firm’s entrance into the CDO market. It describes how Merrill's sales people "scoured the globe for buyers of CDOs" and
distributed some of its riskiest CDO slices through its global network of wealthy clients. One former Merrill executive recalled attending an event at New York's Harvard Club in 2004 at which salesmen described the merits of CDO investing to doctors, hedge fund managers and businessmen. The WSJ writes that "Mr. Ricardi coached salespeple he worked with to stress that mortgage CDOs offered better interest rates than corporate bonds with similar ratings."

MetroPCS is suing over particluar investments known as auction-rate securities. They were marketed as short-term investments that buyers could resell, if they wanted to, in auctions run by Merrill. But this summer, as nervous investors began to shun almost anything connected to subprime mortgages, MetroPCS found it couldn't sell the CDOs it had bought, and it now expects to incur losses.

For its part Merrill says it believes it acted appropriately with MetroPCS and made all of "the appropriate disclosures..."

Subprime Meltdown: The Reckoning

2007-10-24T19:52:00.000-07:00

Here's the latest tally from the New York Times:

Sales of existing homes are falling twice as fast as expected;
Merrill Lynch is taking a $3 billion charge on the mortgage backed securities on its books over and above the $5 billion charge that it announed just two weeks ago;
Total losses to investors and financial firms is now estimated at $400 billion;
Total loss in real estate wealth expected to be between $2 and $4 trillion;
The Joint Economic Committee of Congress predicts about two million foreclosures by the end of next year on homes purchased with subprime mortgages;
Housing prices are predicted to decline between 10-20% over the next year and a half;
A 5% drop in prices is expected to result in a $60 billion decline in consumer spending, because of reduced wealth;
Over the next year and a half, interest rates are due to reset higher on two million homes;
Inventories on unsold existing homes has reached the highest level in 20 years;
From 2003 to March 2006, housing-related businesses added 1.3 million jobs, or about 23 percent of all new jobs created in that period. Since March 2006, the housing industry has lost 383,000 jobs and more layoffs are ahead; and
Layoffs in the financial industry are expected to be just as bad.

On the positive side, you can buy one square inch of a Miami condo for only $35.50. So, if you're a mouse with a taste for South Beach, you're in luck.

Housing Bubble or Credit Bubble

2007-10-24T07:47:00.000-07:00

The Big Picture notes that what we're seeing here is not the result of a bubble in housing prices, but of a bubble in credit:

We can define a bubble as a “trade in high volumes at prices that are considerably at variance from intrinsic values." By that definition, I'm not so sure Housing was a true bubble -- the run up in prices, a doubling over the course of about 7 years, was actually a rational market response to interest rates being dropped to generational (46 year) lows. Trading volumes moved up, but proportionately so. Compare that with the Nasdaq, which doubled from October 1999 to March 2000 on a dynamic of a new paradigm. Trading volumes skyrocketed. When it was over, the Nazz had plummeted 78%.

House prices normally fluctuate in response to interest rate changes due to how they are financed. An example I used a few years ago: The first house I owned had a $300,000 mortgage. Back when interest rates were over 9%, the monthly payment would equal $2,632.71 (30 year fixed 10% mortgage). When mortgage rates plummeted, a buyer could finance a $500,000 purchase with a 6% fixed mortgage for a monthly payment of $2,997.75.

That easy credit resulted in part because lenders no longer worried about whether the loans would be repayed. Instead, they repackaged and sold off their loans through mortgage backed securities:

This drop in lending standards and absurdly easy credit is where things truly went awry: Despite the incredibly accommodative interest rates, lenders simply stopped being concerned about the borrowers' ability to repay loans. My favorite example: California strawberry picker Alberto Ramirez, who despite earning just $14,000 a year, was able to obtain a mortgage to buy a home for $720,000.

The assumption appeared to be that lenders could simply sell the mortgages to Wall Street to be securitized, without worries about delinquencies, defaults and foreclosures.

At the end of the day, it's the investors who purchased CDOs consisting of mortgages owed by strawberry pickers who are going to feel the bubble pop.

If your money market fund didn't give you your money back

2007-10-23T20:33:00.000-07:00

. . . because the fund manager invested in a bunch of SIVs that in turn invested in subprime debt through a series of opaque transactions that would be bad, right?

It's like subprime redux: Some money market fund investors are again wondering if their investments are at risk because another complex investment product has fallen out of favor and become difficult to unload.

* * * *

The uncertainty among money market fund investors centers on what would happen if the SIVs couldn't repay their debts because their assets lost value. Some money market fund investors are, in turn, worried about losing money.

But, don't worry, because that's almost totally not going to happen:

But that's unlikely, says Bruce Bent, who invented the money market fund in 1970. His firm, The Reserve, has about $83 billion in assets and doesn't hold investments in SIVs.

"In the history of the money funds, you've had a number of situations where the management companies have bailed out the funds," he said.

He thinks it's unlikely the companies running money market funds would allow them to "break the buck," as it's known in Wall Street parlance even if the funds lost money on SIV-related investments. The draw of money market funds, of course, is that an investor putting in $1 get $1 back plus interest. If a fund were to, say, give back only 90 cents for every dollar, investors would be outraged.

Still, it's important to remember that money market funds, though considered safe investments, aren't FDIC insured.

Gee, ya think? [h/t Atrios]

Proposed Legislation Povides No Relief For CDO Investors. “The Mortgage Reform and Anti-Predatory Lending Act of 2007” H.R. Bill 3915

2007-10-23T11:55:00.000-07:00

Yesterday, House Democrats introduced legislation to combat abuses in the mortgage lending market, and to provide basic protections to mortgage consumers and investors. Click here for Press Release. The bill, H.R. 3915, the “The Mortgage Reform and Anti-Predatory Lending Act of 2007” reportedly aims to reform mortgage practices in three areas. First, the bill would establish a federal duty of care, prohibit steering, and call for licensing and registration of mortgage originators, including brokers and bank loan officers. Second, the legislation would set a minimum standard for all mortgages which states that borrowers must have a reasonable ability to repay. Third, the legislation attaches limited liability to secondary market securitizers who package and sell interest in home mortgage loans outside of these standards.

Section 204 of the Bill, “Securitizer Liability” is a lot less than advertised in press releases and news reports. Click here for HR 3915 Summary. The idea is to open another pocket to the injured borrower which could be important as mortgage brokers are increasingly insolvent and unavailable to provide a remedy. However, the securitzer can avoid liability by offering the borrower a loan that meets minimum standards or by maintaining various policies and procedures designed to avoid purchasing unqualified mortgages. It is not enough to deter conduct in a billion dollar business where carefully looking the other way means large profits.

More important, there is no protection for unsuspecting customers who purchase bonds or CDOs made up of loans that violate the proposed Bill’s lending rules. The subprime lending debacle was fueled with innocent investor money, as purchasers of mortgage-backed securities bought billions in bonds and CDO tranches they thought were designed to produce an uninspired but steady and safe return. HR 3915 does nothing to hold the securitizers liable to customers for the mortgage backed securities they sell. As long as that lucrative market is unchanged the lifeboat for mortgage borrowers is going to leak big time.

Links/Sources:

HR 3915 Summary.

http://www.house.gov/apps/list/press/financialsvcs_dem/section_by_section_10_22_07_(2).pdf

House Finance Committee Press Release: http://www.house.gov/apps/list/press/financialsvcs_dem/press102207.shtml

New Stories:

New York Times, October 23, 2007, p C1.