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DealBook: Banks Ease Capital Cost of Loans to Brokers

May 1, 2013 by Leave a Comment

James Eastman filed a claim.Devin EastmanJames Eastman filed a claim.

To attract financial advisers, brokerage firms often offer them loans. They are loans with a difference, however.

The loans are essentially payments to lure the advisers — and presumably many of their clients — to the firm and keep them there. The loans are typically forgiven over time if the financial adviser, or broker, meets various performance requirements and does not defect to a rival.

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There is a cost to this practice. The Securities and Exchange Commission requires brokerage firms to hold a significant amount of capital, one dollar for each dollar lent, to protect against loan losses. Then, if the customer does not make good on the loan, the shareholders of the brokerage firm are protected.

Morgan Stanley, however, houses the roughly $6 billion in loans it has made to its financial advisers outside its broker-dealer unit. Segregating these loans allows the bank to set aside just 8 cents for every dollar lent, a much lower capital cost than its rivals Wells Fargo and Bank of America pay. Wells says it keeps all these loans at its broker-dealer, taking a higher capital charge. Bank of America keeps some at its broker-dealer and some in a unit that allows it to set aside less capital. An arbitration case in Tampa, Fla., has opened a window on the different choices that financial firms make about where to house virtually identical assets and how those decisions can reduce a firm’s capital burden. Such calls — rarely disclosed publicly — have become more important since the financial crisis as regulators have pushed banks to hold more capital to protect against potential losses.

“This is classic regulatory arbitrage,” said Rebel A. Cole, a professor of finance at DePaul University. “There is clearly an incentive for Morgan Stanley to hold these loans outside their brokerage operations.”

A spokesman for Morgan Stanley, James Wiggins, said the bank held these loans outside its brokerage operation because they were not related to customer activity.

“While carrying the loans in the servicing entity does decrease the amount of capital held in the broker-dealer subsidiary, it does not reduce the amount of capital held against them at the overall company level,” the spokesman said, referring to the 8-cents-on-the-dollar capital charge for loans held at banks’ holding companies. He said that Morgan Stanley had had this structure for years to take a lower capital charge and that Citigroup had the same structure. Morgan Stanley and Citigroup combined their wealth management operations in 2009.

Neither Bank of America nor Wells Fargo Bank would disclose the value of their broker loans. Wall Street executives with knowledge of the loan structures, who were not authorized to speak on the record, suggested that some banks have not moved the loans outside of the broker-dealer because doing so might draw regulatory scrutiny and would require these banks to rewrite thousands of client contracts.

Morgan Stanley headquarters in New York. An arbitration case has cast light on the way the bank handles loans to employees.Richard Drew/Associated PressMorgan Stanley headquarters in New York. An arbitration case has cast light on the way the bank handles loans to employees.

Details about Morgan Stanley’s arrangement emerged in a recent dispute involving a former financial adviser. The broker, James Eastman, 59, filed an arbitration claim against the bank after he left in 2010, arguing defamation of character and wrongful dismissal. He sought to have his loans from the bank forgiven, something Morgan Stanley was unwilling to do.

After working at Citigroup for years, Mr. Eastman became part of Morgan Stanley after the two firms combined their brokerage operations.

He ended up with two loans. The first was made in 2001, when he started at Citigroup, and it was valued at $942,532. It was forgivable over 10 years, and then subsequently extended. In 2009, he received another loan, valued at $214,648, to encourage him to stay through the merger. Mr. Eastman left the company in 2010, owing roughly $400,000 on the two loans, according to his lawyer, Chris Vernon.

Typically a broker gets a loan that covers several years and is required to pay interest on it. The broker repays the loan using earnings from a parallel bonus pool, assuming certain performance targets are met. If they are not, or the broker bolts to another firm, the broker may be required to pay the loan back.

Mr. Vernon says he was concerned that the entity holding Mr. Eastman’s loans was something called Morgan Stanley FA Notes Holdings, and not the brokerage business, Morgan Stanley Smith Barney. He says he did not want a third party coming after his client later, so he argued that Morgan Stanley FA Notes Holdings, not Morgan Stanley Smith Barney, should be a party to the arbitration case. As part of the arbitration, Jeffrey Gelfand, the chief financial officer of Morgan Stanley’s wealth management business, was called to testify.

Under oath, Mr. Gelfand explained that Morgan Stanley had always housed broker loans outside its broker-dealer. The current holding company, he said, was created in 2009, just weeks before the announcement that Morgan Stanley and Citigroup were combining their wealth management operations.

“Having them away from the broker-dealer just allows us to minimize the regulatory capital associated with them and operate the broker-dealer more efficiently,” he explained to the three arbiters hearing his claim.

He said Morgan Stanley financed its broker-dealer “well in excess of the minimum capital requirement,” so leaving the loans there might not necessarily affect how much capital the bank’s broker-dealer has, but it “reduces the requirement if that was important at any point in time.”

The arbitration was bittersweet for Mr. Eastman. While he received a lesson in Wall Street capital decisions, the arbitration panel denied Mr. Eastman’s claims in March and ordered him to pay back roughly $200,000 of the $400,000 he owed the bank. As well, the panel granted his motion to dismiss Morgan Stanley Smith Barney as a party on his two loans.

Mr. Vernon has now filed a claim in Florida court for lawyers’ fees.

Article source: http://dealbook.nytimes.com/2013/05/01/banks-ease-capital-cost-of-loans-to-brokers/?partner=rss&emc=rss

Filed Under: Global Business Tagged With: , ,

Fair Game: Willow Fund as a Cautionary Tale for Investors

March 30, 2013 by Leave a Comment

With a portfolio that specialized in distressed debt instruments, the Willow Fund had suffered losses of almost 80 percent in the first three quarters of 2012 after its longtime manager switched gears: he had abandoned the corporate debt markets he was familiar with and piled into some colossally bad derivatives trades. The investors, some of whom hadn’t realized they were holding a portfolio filled with risky bets against the debt of European nations, were stunned.

What happened to the Willow Fund is a cautionary tale for any investor who entrusts his or her money to an investment fund. Its demise highlights the dangers when a portfolio manager makes a big change in investment strategy. It also raises questions about how assiduously this fund’s independent directors watched over the manager as he ramped up his portfolio’s risk levels. Both are problems that investors cannot be complacent about.

Ken Boudreau, 70, of Farmington, Conn., is an aggrieved Willow Fund investor who has filed an arbitration case against UBS to recover his losses. Mr. Boudreau began putting money into the fund in mid-2009, investing a total of $350,000. His losses were $300,000.

In an interview, Mr. Boudreau said his UBS brokers had contended that the fund’s investment in distressed debt securities positioned it well for gains in 2009 as the economy recovered from the credit crisis. The experience and track record of Sam S. Kim, the portfolio manager overseeing Willow since it began operations in 2000, was another selling point. Mr. Kim was expert at analyzing distressed debt instruments, Mr. Boudreau said his brokers told him.

“I try to be a disciplined buyer and seller, buying in when markets are down,” Mr. Boudreau said in an interview. “In mid-2009, distressed debt seemed to me a home run.”

Which it might have been, had Mr. Kim, the money manager, not plunged headlong into credit default swaps on government debt of Germany, Sweden, France, Spain and other nations. In these trades, Mr. Kim was buying a type of insurance against the nations’ defaulting; his investors, therefore, would benefit if problems in these nations worsened.

According to regulatory filings, the Willow Fund had an impressive run through 2006. That year, the fund returned almost 25 percent on a portfolio of corporate bonds, bank loans and corporate repurchase agreements, a financing arrangement. Credit default swaps amounted to a minuscule 0.18 percent of the Willow Fund in 2006.

That portfolio was consistent with the fund’s description in regulatory filings. It would “maximize total return with low volatility by making investments in distressed investments,” the filings said, “primarily in debt securities and other obligations and to a lesser extent equity securities of U.S. companies that are experiencing significant financial or business difficulties.” The fund might also hedge its portfolio against risks, using credit default swaps, the filings said, or use those instruments “for non-hedging purposes.”

In 2007, the Willow Fund’s exposure to credit default swaps started rocketing. That year, Willow also began generating losses — 9.1 percent, and then 18 percent in 2008 when the credit crisis hit.

As Mr. Kim’s view soured on world economies, particularly in the euro zone, he began trading on these concerns, a letter from UBS to investors said. That meant more of the portfolio went into credit default swaps.

By the end of 2008, corporate bonds amounted to only 6 percent of the portfolio, down from 29 percent a year earlier. The value of the credit default swaps, meanwhile, had ballooned to 25 percent of the portfolio from 2.6 percent in 2007. By 2009, when Mr. Boudreau began investing, credit default swaps amounted to 43 percent of Willow’s portfolio, a fact that Mr. Boudreau said he did not know.

THE fund’s disclosures that it might invest in credit default swaps gave insufficient warning to investors of the risks in these strategies, said Jacob H. Zamansky, a lawyer who represents Mr. Boudreau and other investors in the Willow Fund.

Mr. Zamansky pointed to Securities and Exchange Commission guidance in 2010 telling mutual fund managers in general to be specific about strategies involving derivatives. The S.E.C. was concerned that some funds were making generic disclosures about derivatives that “may be of limited usefulness to investors in evaluating the anticipated investment operations of the fund, including how the investment adviser actually intends to manage the fund’s portfolio and the consequent risks.”

Article source: http://www.nytimes.com/2013/03/31/business/willow-fund-as-a-cautionary-tale-for-investors.html?partner=rss&emc=rss

Filed Under: Economy News Tagged With: , ,