Auction Rate Securities
By: Craig McCann and Edward O'Neal (Oct 2010)
Auction Rate Securities (ARS) were marketed by broker-dealers to investors, including individuals, corporations and charitable foundations as liquid, short-term, cash-equivalent investments similar to traditional commercial paper. ARS's liquidity and similarity to short-term investments were entirely dependent on the presence of sufficient orders to buy outstanding ARS at periodic auctions in which they were bought and sold subject to a contractual ceiling on the interest rate the issuer would have to pay. If the demand for an ARS was too low to clear the market, broker dealers sponsoring the auction could place bids just below the maximum interest rate to clear the auction. The lower the public demand for an issue, the larger the quantity broker dealers had to buy to avoid a failed auction.
Participating broker dealers had better information than public investors about the creditworthiness of the ARS issuers and were the only parties with information about the broker dealers' holdings and inclination to abandon their support of the auctions. This severe asymmetry of information made public investors in ARS vulnerable to the brokerage firms' strategic behavior. In this paper, we explain what auction rate securities were, how they evolved, how their auctions worked, and why their flaws caused them to become illiquid securities.
Leveraged ETFs, Holding Periods and Investment Shortfalls
By: Ilan Guedj, Guohua Li, and Craig McCann (Aug 2010)
Published in the Journal of Index Investing, Winter 2010, Vol. 1, No. 3: pp. 45-57.
Leveraged and Inverse Leveraged ETFs replicate the leveraged or the inverse of the daily returns of an index. Several papers have established that investors who hold these investments for periods longer than a day expose themselves to substantial risk as the holding period returns will deviate from the returns to a leveraged or inverse investment in the index. It is possible for an investor in a leveraged ETF to experience negative returns even when the underlying index has positive returns. This paper estimates the distributions of holding periods for investors in leveraged and inverse ETFs.
The SLCG study shows that a substantial percentage of investors may hold these short-term investments for periods longer than one or two days, even longer than a quarter. The study estimates the investment shortfall incurred by investors who hold leveraged and inverse compared to investing in a simple margin account to generate the same leveraged or short investment strategy.
The study finds that investors in leveraged and inverse ETFs can lose 3% of their investment in less than 3 weeks, an annualized cost of 50%.
A CMO Primer: The Law of Conservation of Structured Securities Risk
By: Craig McCann (Jun 2007)
The collapse of Brookstreet Securities and bailout of two Bear Stearns hedge funds have focused attention on collateralized mortgage obligations (CMOs). These recent CMO losses closely parallel CMO losses in 1994 when a significant increase in interest rates caused many bond mutual funds to fall in value far more than expected. Today's CMO losses resulted from the relatively recent introduction of CMOs with substantial credit risk and the inadequate or misleading way in which that credit risk was disclosed. Dr. McCann provides a selective history and a brief description of CMOs.
