As mutual fund companies turn out derivatives- and leveraged-laden offerings, regulators are becoming increasingly concerned that funds, and the financial industry at large, are forgetting the lessons of the Great Recession by returning to complicated, high-risk products.
With the Dow crossing 11,000 last week and the economy on the mend, fund managers are beginning to look for creative ways to spike performance and meet demand for non-correlated securities, but regulators are wary about letting them make the same mistakes.
The Securities and Exchange Commission is hoping to reign in investment bankers and loan originators' use of structured products with proposed changes to Regulation AB, requiring more detailed information about asset-backed securities. As for funds, there are two notable lawsuits against bond funds that burned investors by investing in risky areas instead of safe and conservative bonds.
"The rules we are proposing stem from lessons learned during the financial crisis," said SEC Chairman Mary Schapiro.
The rampant securitization of a wide range of loans-particularly in the mortgage-backed area-played a central role in the financial crisis, Schapiro said. While securitization provided trillions of dollars of liquidity to virtually every sector of the economy, it also fostered poor lending practices by encouraging lenders to shift their risk of loss to investors, she said.
In the buildup to the big crash of 2008, financial innovators crafted a variety of extremely complicated financial products that mixed, matched, sliced and diced normal investments like stocks, bonds and Treasuries with other extremely complicated products, including securitized, bundled subprime loans and reverse convertible structured products.
Ratings agencies didn't know what these products were really worth or even what was in them, yet rated a wide majority triple-A. This stamp of approval coupled with tremendous yields, lured investors of all sizes-money market funds included-in.
When the house of cards finally came tumbling down in September 2008, no one wanted anything to do with these toxic products.
"In the past two decades, the investment company marketplace has been significantly reshaped by the use of derivative instruments," said Andrew "Buddy" Donohue, director of the SEC's Division of Investment Management. "During this period, investment companies have moved from relatively modest participation in derivatives transactions limited to hedging or other risk management purposes to a broad range of strategies that rely upon derivatives as a substitute for conventional securities."
Donohue said mutual funds that mimic hedge fund strategies, typically through the use of derivative products, have become commonplace. New investment company categories have emerged, including absolute-return funds, commodity return funds, alternative investment funds, long/short funds and leveraged and inverse index funds, he said.
"With so many derivative instruments available to enhance an investment strategy, a fund's manager can design a portfolio in a multitude of ways to create different exposures that are unrelated to the amount of money invested and are not necessarily reflective of the types of instruments the fund holds," Donohue said.
Derivative-based investment products, such as collateralized debt obligations, collateralized mortgage obligations and swaps can be difficult to price, he said.
"With the advent of such complexity in our markets and the increased use of derivatives by funds, I believe the oversight of derivatives cannot be business as usual," he said.
In a recent decision in a class-action suit against Charles Schwab's YieldPlus Fund, which had 50% of its assets in mortgage-backed securiites, the U.S. District Court for the Northern District of California ruled that funds may not significantly alter their previously stated concentration policies without shareholder approval.
In this case, the Schwab fund was tasked with providing investors with high yields, but was also prohibited from investing more than 25% of its assets in any one industry. The portfolio manager and fund board decided that mortgage-backed securities weren't technically an industry but an investment class and reasoned that the fund could therefore invest 50% of its assets in mortgage-backed securities. Yields were great and investors mostly stayed in the fund, until the mortgage sector tanked.
The court's issue was not that the manager changed the entire composition of the fund on a technicality, but that the change was made without a shareholder vote.
"Once they have gathered in the investments, the fund managers and promoters must honor the stated concentration policy and may exceed the limit only after a shareholder vote," the court said.
In a separate case, the SEC, along with the Financial Industry Regulatory Authority, has filed fraud charges against Morgan Keegan & Co. after its Regions Morgan Keegan Select Intermediate Bond Fund-which was marketed as a relatively safe and conservative fixed-income mutual fund-turned out to be secretly exposed to investments in mortgage- and asset-backed securities, as well as subordinated tranches of structured products including, subprime products.
The complaint against Morgan Keegan alleges that the firm was aware of its negative performance in early 2007 but failed to warn its brokers or revise its advertising materials to reflect this news.
"This scheme had two architects-a portfolio manager responsible for lies to investors about the true value of the assets in his funds, and a head of fund accounting who turned a blind eye to the fund's bogus valuation process," said Robert Khuzami, director of the SEC's Division of Enforcement.
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