Regulators in five states are investigating whether Morgan Keegan, a Memphis-based brokerage firm, failed to disclose the risks associated with seven of its mutual funds.  These funds were loaded with debt positions that some have labeled “toxic.”

A number of lawsuits have been filed regarding these Morgan Keegan mutual funds.  In addition to the lawsuits, dozens of individual investors have filed FINRA arbitration claims against Morgan Keegan and its portfolio manger, James C. Kelsoe.

Morgan Keegan promoted Mr. Kelsoe’s funds as a stable source of income.  Sales materials for the High Income fund noted its “relative conservative credit posture” without “excessive credit risk.”  In reality the funds were loaded with risky asset-backed subprime mortgages securities and other questionable debt obligations.

One particularily troubling aspect of these cases is the apparent targeting of these funds to seniors and small, inexperienced investors. 

These people are exactly the type of investors who were seeking income and stability for their hard-earned savings and who could not afford to be exposed to risk.  In addition, these investors were least likely to be able to understand the complexities of the investments they held.

Business Week recently reported the story of Katherine and Lester Poer.  Mr. Poer is 81 years old.  The couple, on the advice and recommendation of a Morgan Keegan broker, took the $250,000 they received from a land sale and purchased the RMK Select Intermediate Bond fund. 

The RMK Intermediate fund has lost over 86% of its value in the last year and the Poers  have lost over $200,000 in their investment.

Unfortunately, their story is not unique.  Many other investors have found themselves in a similar situation.  Some are now retaining counsel to help them recover some of their losses.         

Over the past few weeks, some of the largest closed-end fund companies, including Eaton Vance Corp. and Nuveen Investments Inc., have disclosed plans to redeem their auction-rate preferred securities. This solution may allow some irritated investors to cash out quickly.   

However, many other closed-end fund companies have yet to announce plans to redeem their auction-rate preferred securities.  The reason given is to protect their common shareholders.  

Companies are worried cashing out preferreds right now will hurt their common shareholders. Therefore, the preferred holders may have to wait months or even years before they are able to cash in.   

Prominent closed-end operations that have not publicized a redemption plan include; Allianz SE’s Pimco and Nicholas-Applegate funds, Lehman Brothers Holdings Inc.’s Neuberger Berman funds, Bank of New York Mellon Corp.’s Dreyfus funds, and Pioneer Investments. Together they have totaled $7.6 billion of auction-rate preferred. 

Auction-rate preferreds are long-term securities that functioned like short-term investments. But, when the market stopped functioning like normal, buyers for these securities vanished in auctions. Holders have been stuck in a slump by fund companies since the credit crunch weakened in February.

Ed Dowling owns preferreds issued by five different companies, including $300,000 in Neuberger Berman, which is the only one yet to redeem any his securities. He is questioning the future of his funds and is even considering selling on the secondary market at a loss.   

The problem fund managers are struggling with is whether replacing the auction-rate debt with other leverage would be more expensive and would consume fund earnings. Action-rate financing has the benefit of longer maturities than bank loans and bonds typically have. Funds that replaced the preferreds with bank borrowings run a risk that the bank may charge a higher rate to extend the loan, or not extended it at all. 

According to the Wall Street Journal, when the market started declining there were about $64 billion of these securities issued by closed-end funds. Now, just 31 percent has been redeemed, or plan to be shortly.

According to reports, Wachovia’s money-management unit, Evergreen Investments, will be liquidating $403 million from its Ultra-Short Opportunities Fund. The fund, which is primarily backed by mortgage securities, has lost 20% this year alone and has dropped 18% just this month.  

The failure of this fund highlights the ongoing problem brokerage firms are having in pricing the value of their investors’ illiquid investments. Bond-fund managers are being pressed to ensure their holdings are valued correctly so investors receive the correct amount of liquid funds from their shares.  

As of March, two thirds of Ultra-Short Opportunities assets consisted of home-loan securities that were not backed by government entities. The fund also carried only 70% ($9.1 million) of the original value of Novastar ABS CDO I Ltd. because it was created from low-rated subprime-mortgage bonds.  

Wachovia wrote down the value of its bank-owned insurance policies this spring, which resulted in a loss of $708 million on May 6th. The bank also paid a $144 million settlement over complaints of telemarketers and payment processors stealing from customer accounts under the supervision of former Chief Executive Kennedy Thompson.  

Although debt-pricing companies such as Interactive Data Corp. and Street Software Technology, Inc. are making strong efforts to place correct valuations on securities, difficulties arise in getting an accurate price when high-yield or non-investment-grade bonds aren’t trading in high volumes.  

Other firms such as Charles Schwab and Fidelity Investments are facing lawsuits from investors who have suffered substantial losses due to the sub-prime mortgage crisis.

In the four months since auction-rate securities collapse, many investors are left with nothing else to do, but take out loans, sell their securities at discounts, file arbitration cases against brokers, or wait and hope the market returns to normal.  

One of the many investors affected by the current market was advised by her broker to invest her entire $375,000 divorce settlement into auction-rate securities last December. She was planning on using this money for her daily needs, but has yet to see a dime since the market froze up.  

Her brokerage, UBS AG, offered a margin loan backed by her account to get by with day-to-day expenses. But, later UBS marked down the value of the securities and demanded she repay part of the loan. She received her second margin call requesting money last week after UBS marked down her securities again by about 50%.  Unfortunately, this is not uncommon.    

An investor with A.G. Edwards fell into a similar situation last September when she came into $1.25 million from the sale of a business. She planned on using the funds for a tax payment. Her broker also advised she stash her money into auction-rate securities issued by mutual-fund companies.  She eventually had to take out a home-equity line of credit to pay taxes.  She left A.G. Edwards and moved to a new firm. The new firm advised her to sell the securities (for a loss) on a secondary market- the Restricted Stock Trading Network.  

Brokers recommended auction-rate securities to investors who wanted a safe, liquid investment. Individuals and companies purchased auction-rate debt from municipalities, charities, student lenders and closed-end mutual funds for years because of the pitch as a safe investment with a higher yield than a money market fund. 

In February, it became almost impossible to find bidders for these auctions as the subprime crisis extended to nearly all areas of the credit market. Wall Street firms refused to support the $330 billion market as well, causing it to freeze up and leave many investors out of luck. 

The student-loan backed security, an $80 billion portion of the auction-rate market, was hit predominantly hard because the interest rates reset to such low levels, in some cases 0%. The interest rates on auction-rate securities issued by mutual finds or municipalities have been much stronger, because when the auction fails the rates automatically reset above a benchmark rate.   

According to the Financial Industry Regulatory Authority, the securities industry’s nongovernmental regulator, about 80 arbitration claims dealing with auction-rate securities have already been filed.  More are coming.

The ripples from the subprime crisis have reached an unlikely and surprising sector, municipal bonds.  Defaults of subprime mortgages have started a sequence of problems in the credit markets over the past year eventually impacting the municipal bond market (munis).  

Last summer losses in the taxable bond sector and the debt tied to subprime mortgages led to serious write downs. During the last two weeks of February the bond market essentially crashed, resulting in the worst week in the municipal bond market in over a decade. Municipal yields went up about 50 basis points and municipal bond funds declined by anywhere from four to ten percent, which is unheard of over such a short period of time. The media offered little explanation, leaving many investors in the dark. 

In the past bond insurers were capitalized, and the major firms (including MBIA and FGIC) were rated AAA, the highest credit quality. The ratings of the firms are extended to the bonds under guarantee. This caused certain bonds to receive AAA ratings when they should have been investment grade or lower. The higher ratings made it possible for a variety of fiduciaries to own the bonds, and make interest costs lower.  

Potential losses are still unknown, and attempts to recapitalize in order to save their AAA rating are ongoing. But, the damage has been done and bond insurers are being downgraded. According to Bond Buyer, as of April 15, FGIC, once the firm with the strongest capital base, had been downgraded to barely investment grade or slightly below.  

The hesitancy of bond insurers’ ratings parallels the hesitancy of issuers’ underlying ratings. As a result, many bonds are lowering to the underlying ratings, and in some cases even lower.   

Since the downfall first started, there have been signs that the municipal bond market would have serious consequences if bond insurers downgrade, such as the values of munis dropping significantly. These downgrades also have harmful effects on banks’ balance sheets, because some of the corporate debt is owned by major money center banks.  

Munis are relatively new, and gained popularity because the bonds are exempt from federal taxes, as well as city and state taxes if living in the state it’s issued. They also have extremely low default rates and are dominated by the individual investors, who purchase about two-thirds of the bonds.

Bloomberg is reporting that Charles Schwab Corp., the largest U.S. online brokerage, may set aside $260 million to settle investors’ claims regarding losses from their Yield Plus mutual fund.  To date, eight different class actions have been filed against Charles Schwab relating to their Yield Plus fund.

There are a number of problems with this rumored settlement.  The first is that a Schwab spokesman has commented that it is “inappropriate and misguided” at this early stage to speculate regarding settlement.  Secondly, the Bloomberg report only addresses the class actions that have been filed.  A number of investors, seeking better outcomes, are choosing to participate in their own individual arbitrations. 

Charles Schwab is accused of misleading investors by marketing, offering and selling its Yield Plus fund as only “marginally” riskier than cash.  From July 1 through April 30, investors in this fund lost $1.3 billion.   

According to Bloomberg, securities class action settlements typically begin around 1% of investors’ losses.  The $260 million figure being reported represents 20 percent of losses.  Our firm believes that investors may stand a better chance of recieving a greater recovery of their losses through individual arbitration actions.

Investors of the Charles Schwab Yield Plus mutual fund are encouraged to contact an attorney to discuss their options.        

Morgan Keegan investors critically affected by the subprime mortgage crisis are taking a stand. Recent allegations claim the company inadequately managed funds and unjustly explained losses during the subprime market collapse. Many investors are also accusing Morgan Keegan of fraud because they presented these funds as “safe and stable investments.”

One investor seeking to recover damages filed an arbitration claim with FINRA against Morgan Keegan for $4 million last week.

The claim alleges misrepresentation and omission of information in its registration statements and prospectus releases with regard to the funds’ investments in collateralized debt obligations, resulting in exposure to the subprime mortgage market. Further damages came from false and misleading statements issued by Morgan Keegan with regard to the funds’ safety, and capacity to generate income.

The damages are in connection with the sale of unsuitable funds which include; the RMK High Income Fund (RMH), the RMK Multi-sector High Income Fund (RHY), the RMK Advantage Income Fund (RMA), the RMK Strategic Income Fund (RSF) and the Regions MK Select High Income fund (MKHIX).

There are many other investors in the same situation hoping to recover varying amounts in claims already filed against Morgan Keegan.

Charities and other smaller investors have also been affected by Morgan Keegan. Last October Maddox Hargett & Caruso represented an Indiana-based charity by filing a FINRA claim regarding a loss in a RMK fund totaling almost $50,000.

Investors, big or small, are choosing the arbitration process to recover their damages instead of waiting for a class action lawsuit that could take years to settle. We encourage all investors of Morgan Keegan funds to contact us.

As the landscape begins to clear for some holders of auction rate securities, for those holding $85 billion of such securities backed by student loans, the future is not so bright.

Student loan-backed auction rate bonds, sold as safe, liquid, cash equivalents, have been one of the worst performing segments of the market.  The problem is that the issuers of these student loan ARS have little or no ability to raise additional funds to redeem them.  Adding fuel to the fire is that the interest rates being paid on these ARS have fallen to zero.  The result, many investors are left holding positions that are illiquid and paying no interest.

Considering most of these investments were sold to investors seeking short-term growth with little risk and liquidity, the current prospects for the future are unacceptable. 

According to Aaron Pressman’s May 28, 2008 piece from BusinessWeek Online, while many municipalities have redeemed or are planning on redeeming the bonds they have issued, only one student loan issuer has announced a rescue plan.  The secondary markets are also failing to offer a solution for holders of these securities.

It is being reported that investors are likely to be stuck with as much as $70 billion worth of student loan-backed securities.  According to JP Morgan analyst Alex Roever, “current investors are at risk of having to hold positions until maturity, which in a few cases may be 40 years away.”            

Individual investors are not the only ones experiencing pains due to the frozen auction rate securities markets.  First quarter earnings show that more than 400 companies held at least $30 billion in these investment products.

Since February, the $330 billion auction rate market has largely been frozen.  Failed auctions continue even now, some four months later.  Large companies are struggling with how to price their holdings.  About half of the companies have written down the value of these securities.  The average markdown was 13.2%.

Companies are now looking for ways to handle their lack of liquidity.  Some are turning to secondary markets like Restricted Securities Trading Networks.  RSTN has arranged 200 auction rate sales with discounts ranging from 2% - 30%.

 About 25% of the $330 billion auction rate securities market has been bought back by municipalities or refinanced with new debt.  The remaining are likely not worth their face value. 

Ben Stein (yes, that Ben Stein from Ferris Bueller’s Day Off notoriety) penned an insightful piece in Sunday’s New York Times.  Mr. Stein, a frequent contributor to the Times, asks “how on earth did the credit crisis on Wall Street become such a catastrophe?”  Many investors are wondering the same thing.

 The NY Times Article, Wall Street, Run Amok, ponders a number of questions. Namely, weren’t fail-safe devices in place to guard against risk?  Weren’t government watchdogs supposed to be keeping an eye on things?  What about the policing role rating agencies?  Why are we in this mess?

In search of answers, Mr. Stein points the reader to a speech given on April 8th by David Einhorn.  Mr. Einhorn, who runs the successful hedge fund Greenlight Capital, stated that those who run big investment banks have an incentive to maximize assets and leverage themselves into trouble because their compensation is a function of how much debt they can pile on. 

Mr. Stein simplifies this position as follows: “If they (the investment banks) can use relatively low-interest debt to generate slightly higher returns, the firms earn more revenue and executive pay increases.”  Problems therefore arise concerning what type of assets are acquired with the debt.  

The most troubling aspect of Mr. Einhorn’s speech is his observation that the S.E.C. allowed brokerage firms to set their own valuations on assets and liabilities that were by their nature difficult to value.  The result, in essence, was that the hens were allowed to guard the hen house.

This Wall Street culture, and limited examination from regulators, has created an interesting paradox.  It is the old “heads I win, tails you lose” analogy.  If Wall Street’s big bets pay off, it is the firms and their executives who reap the benefit.  However, when things go south (as they did with the recent subprime debacle), it is individual investors and taxpayers who are left to pick up the pieces.

Mr. Stein’s conclusion is that the inmates are running the asylum.  I cannot disagree.