Call Options on Hedge Funds: Double Markups and Detrimental Mispricing
(Feb 2013)
A recently settled FINRA Arbitration case was brought by an investor who was sold a $2M call option on a basket of hedge funds by a large investment bank. The case was notable for two reasons. First, the investment bank charged a 25 percent markup on the fair value of the option. This large amount was charged even though the investment bank -- call it Investment Bank 1 -- simultaneously laid off all of its risk by buying an equivalent call option from another investment bank -- call it...
FINRA Dispute Resolution Statistics 2012
(Jan 2013)
Last week, we covered NERA's analysis of SEC settlements during FY2012. This week, we're taking a look at FINRA's recent release of their dispute resolution summary statistics. FINRA arbitration is a common way for investors to pursue restitution for damage caused by fraud, negligence, or other fiduciary breaches. FINRA provides a detailed summary of the arbitration process and claims can be filed either online or by mail.
Through December of this year, FINRA reports that the number of new...
Is FINRA Arbitration Constitutional?
(Sep 2012)
Since 1987, when the Supreme Court upheld the mandatory arbitration provision found in brokerage customer agreements (Shearson/American Express v. McMahon - 482 U.S. 220 (1987)), most disputes between broker-dealers and their customers or employees have been adjudicated through the FINRA Dispute Resolution process. Their proceedings are not open to the public, no public record is kept, and most decisions are not explained. FINRA arbitrators come from all walks of life, although many are...
Poor Incentives and Predatory Lending in Municipal Finance
(Aug 2012)
Last year, Poway Unified School District had a problem. A decade earlier, it had started a program to modernize its aging schools. In 2008, voters had approved additional funding for the project under the condition that the school board could not raise taxes further. Unfortunately, by 2011, the project needed an additional $105 million to complete. But because they could not raise taxes, they could not issue the kind of tax-backed bonds (called general obligation bonds) that usually fund...
High-Frequency Trading and Market Volatility
(Apr 2012)
The "flash crash" of May 6, 2010 -- when the Dow Jones Industrial Average dropped by 9% in a few minutes and quickly regained ground -- has naturally drawn wide attention. Although the sharp drop was not directly triggered by high-frequency traders (traders who execute trades based on complex algorithms and rarely hold a position more than a day), they have been blamed for fueling the selling after a mutual fund complex initialized a program to sell a large amount of E-Mini S&P 500...
Hedge Fund Correlation with Broad-Based Indexes Increases Dramatically
(Mar 2012)
As Bank of America-Merrill Lynch Global Research's Mary Ann Bartels showed last year, the correlation of hedge fund monthly returns with broad based stock market indexes has recently hit historic highs. We decided to look into this phenomenon and determine whether or not it is persisting.
In the following plot, we show the monthly returns for the S&P 500 index as well as the Dow Jones Credit Suisse Core Hedge Fund Index (representing an aggregation of several hedge fund investment...
Credit Risk in the Municipal Bond Marketplace
(Feb 2012)
Municipal bonds are debt securities issued by city, county or special-purpose government units (known as municipal authorities). This debt is typically issued to fund public works projects such as health care, construction projects or education. Because the interest from municipal bonds is usually exempt from federal income tax (one notable exception is Build America Bonds); the municipal bonds are especially attractive to high tax-bracket individuals. We will discuss some specifics of the...
Déjà Vu: Non-Traded Business Development Companies
(Feb 2012)
Last week we posted an introduction to non-traded REITs that highlighted the many risks inherent to those investments. As it happens, another non-traded investment has been growing in popularity, but has an almost identical set of risk factors and has recently caught the attention of regulators: non-traded business development companies (BDCs).
The resemblance between non-traded REITs and non-traded BDCs is uncanny. Both are special business classes created by Congress in the mid 20th...
Did ARS Interest Payments Adequately Compensate Investors After the Failures?
(Feb 2012)
Auction Rate Securities (ARS) are floating interest rate debt issued primarily by municipalities, mutual funds, and special purpose trusts. ARS were marketed as short-term, cash-equivalent investments similar to commercial paper but any similarities with short-term investments were superficial and misleading. ARS are long-term debt traded in periodic auctions with prices fixed at par. The auction-determined interest rate was constrained by a maximum rate which could prevent the auctions from...
Did BoA's 2007 CLOs Defraud Investors?
(Jan 2012)
We have posted a new paper today showing that on July 2007 Banc of America appears to have transferred at least $35 million of previous losses to unsuspecting investors in two of its CLO offerings - LCM VII and Bryn Mawr II. Investors ultimately lost nearly $150 million in October 2008 when these two CLOs backed by leveraged loans were liquidated.
Leveraged loans issued to below investment grade corporations were frequently extended by a syndicate of lenders intending to re-sell...
