Leveraged Municipal Bond Arbitrage: What Went Wrong?
By: Geng Deng and Craig McCann (Oct 2010)
Published in The Journal of Alternative Investments, Spring 2012, Vol. 14, No. 4: pp. 69-78.
In this article, we explain that, while marketed as an arbitrage strategy, the leveraged municipal bond strategy was simply an opaque high-cost, highly leveraged bet on the value of call options, interest rates and liquidity and credit risk. Brokerage firms misrepresented the strategy by comparing the yields on callable municipal bonds with the yields on non-callable Treasury securities without adjusting the yields on municipal bonds for their embedded call features and by ignoring 30 years of published literature which demonstrates the remaining difference in after-tax yields is compensation for liquidity and credit risk. We also show that much of the losses suffered by investors were suffered during a period of relatively routine interest rates and not during an unprecedented interest rate environment.
Related Awards:
- Puglisi v Citigroup - $750,000 MAT Five Award
- Young v Deutsche Park Securities - $1 million Aravali Fund Award
- Hosier et al v Citigroup - $54.1 million MAT Finance, MAT Two, MAT Three, MAT Five Award
- Coleman v Citigroup - $230,667 ASTA Five Award
- Beard v Citigroup - $336,000 ASTA Five Award
- Barnett et al v Citigroup - $2,428,000 MAT Five Award
The Anatomy of Principal Protected Absolute Return Notes
By: Geng Deng, Ilan Guedj, Joshua Mallett, and Craig McCann (Jul 2010)
Published in the Journal of Derivatives, Vol. 19, No. 2, pp. 61-70, 2011.
Principal Protected Absolute Return Barrier Notes (ARBNs) are structured products that guarantee to return the face value of the note at maturity and pay interest if the underlying security's price does not vary excessively.
The SLCG study derives four closed-form valuation approaches which are considered as representative methodologies on valuing structured products. The approaches are: 1) decomposing an ARBN's payoff into double-barrier linear segment options, 2) decomposing an ARBN's payoff into double-barrier call and put options, 3) transforming an ARBN's path-dependent payoff rule into a path-independent payoff rule which significantly simplifies the derivation of product value, and 4) using PDE (Partial Differential Equations) to model an ARBN's payoff and calculate its value. The study shows the four methodologies to value 214 publicly-listed ARBNs issued by six different investment banks. Most of the products are linked to indices such as the S&P 500 Index and the Russell 2000 Index.
The study finds that the ARBNs' fair price is approximately 4.5% below the actual issue price. Each of the ARBN's fair price is stable across all four valuation methodologies.
What TiVo and JP Morgan teach us about Reverse Convertibles
By: Geng Deng, Craig McCann, and Edward O'Neal (Jun 2010)
Reverse convertibles are short term, unsecured notes issued by brokerage firms including JP Morgan, Barclays, Citigroup, Morgan Stanley, Wachovia, Lehman Brothers, and RBC that pay less than the notes' face value at maturity if the price of the reference stock or the level of the reference stock index declines substantially during the term of the note. The SLCG study finds that brokerage firms overcharge for reverse convertibles so significantly that the expected return on these complex investments is actually negative and that reverse convertibles continue to be sold at inflated prices only because investors do not fully understand these products.
The SLCG study reports that despite substantial overpricing in the offerings and the significant losses on the reverse convertible notes in 2008 and 2009, there have been a substantial number of new issues of these dubious investments by JP Morgan, Barclays and many others brokerage firms in 2010. The study illustrates its main themes with JP Morgan's May 14, 2010 TiVo-linked reverse convertible.
Oppenheimer Champion Income Fund
By: Geng Deng and Craig McCann (May 2010)
During the second half of 2008, Oppenheimer's Champion Income Fund lost 80% of its value - more than any other mutual fund in Morningstar's high-yield bond fund category. These extraordinary losses were due to the Fund's investments in credit default swaps (CDS) and total return swaps (TRS). The Fund used CDS and TRS to leverage up the Fund's exposure to corporate debt and asset-backed securities, including Mortgage-Backed Securities and swap contracts linked to Residential and Commercial Mortgage-Backed Securities indices.
What Does a Mutual Fund's Term Tell Investors?
By: Geng Deng, Craig McCann, and Edward O'Neal (Apr 2010)
Published in the Journal of Investing, Summer 2011, Vol. 20, No 2: pp. 50-57.
In a previous article, we highlighted a flaw in the average credit quality statistic frequently reported by bond mutual funds. That statistic understates the credit risk in bond portfolios if the portfolios contain bonds of disperse credit ratings. In this article we address a similar problem with bond mutual funds' reporting of the average term of their portfolios. The somewhat ambiguous nature of this statistic provides an opportunity for portfolio managers to significantly increase the funds' risks, credit risk in particular, by holding very long-term bonds while claiming to expose investors to only the risks of very short-term bonds.
Morningstar uses a fund-provided statistic - the average effective duration - to classify funds as ultra short, short, intermediate or long-term. Funds have figured out how to hold long-term bond portfolios yet be classified as ultra short-term and short-term bond funds. We show that extraordinary losses suffered by these funds in 2008 can be explained by the how much the bond funds' unadulterated weighted average maturity exceeded the maturities typically expected in short-term bond funds.
What Does a Mutual Fund's Average Credit Quality Tell Investors?
By: Geng Deng, Craig McCann, and Edward O'Neal (Nov 2009)
Published in the Journal of Investing, Winter 2010, Vol. 19, No. 4: pp. 58-65.
The SLCG study explains that the Average Credit Quality statistic as typically calculated by the mutual fund companies and by Morningstar significantly overstates bond mutual funds' true credit quality. This statistic is based on Standard & Poor's and Moody's assessment of the credit risk of the individual bonds in the portfolio and is reported to mutual fund investors using the familiar letter scale for rating the credit risk of bonds.
The study concludes that, for instance, funds that have the credit risk of a portfolio of BBB-rated bonds often report an Average Credit Quality of A or even AA and that given how this statistic is calculated, portfolio managers can easily manipulate their holdings to significantly increase their credit risk and thereby their yield without increasing their reported credit risk at all. Since bond fund managers compete for investors based on yield and risk, the authors find that fund managers who report Average Credit Quality have the ability and the incentive to increase but underreport the credit risk in their bond mutual fund portfolios.
Structured Products in the Aftermath of Lehman Brothers
By: Geng Deng, Guohua Li, and Craig McCann (Nov 2009)
SLCG's prior research showed that structured products were poor investments because they were significantly overpriced when offered and were, at best, thinly traded thereafter. SLCG concluded that overpriced structured products survived in the marketplace because structured products' opaqueness obscured their true risks and costs and the high fees earned by underwriters and salespersons.
The current SLCG study presents a brief history of the structured products program at Lehman Brothers and illustrates many of its points with Lehman structured products examples including Principal Protected Notes, Enhanced Return Notes, Absolute Barrier Notes, Steepeners and Reverse Convertibles. The study reports that the spectacular failure of Lehman brothers in September 2008 left investors holding more than $8 billion face value $US-denominated structured products. Dr. Craig McCann, the study's principal author, explained that the Lehman experience is especially instructive of the opportunity for mischief presented by financial engineering; faced with increasing borrowing costs Lehman stepped up its issuance of structured products where its credit risk would not be priced into the debt.
Charles Schwab YieldPlus Risk
By: Geng Deng, Edward O'Neal, and Craig McCann (Jul 2009)
From June 2007 through June 2008, investors in YieldPlus (SWYSX and SWYPX) lost 31.7% when other ultra short bond funds had little or no losses. Schwab had marketed YieldPlus as a low risk, higher yielding alternative to money market funds.
The report concludes that YieldPlus's extraordinary losses occurred because the fund held much larger amounts of securities backed by private-label mortgages than other ultra short bond funds. In doing so, Schwab's fund violated concentration and illiquidity limits stated in its prospectus. These private-label mortgage-backed securities holdings had given YieldPlus a slight advantage over its peers prior to 2007. Unfortunately, the extra yield was an order of magnitude smaller than the losses that followed when the value of structured finance securities - especially those backed by mortgages - dropped significantly.
SLCG also found that Schwab significantly inflated the value of YieldPlus's holdings and therefore its NAV in late 2007 and early 2008. By inflating the YieldPlus fund's NAV, Schwab provided existing investors incorrect information about the value of their investments and caused new investors to overpay for shares in YieldPlus.
