Arresting a billionaire or two must have seemed like a good way to get started.  Earlier this year the SEC went after Allen Stanford, who like Madoff operated unmolested for years.  Now they have Raj Rajaratnam in handcuffs for alleged insider trading.

Rajaratnam, if you haven’t heard of him, is the founder and head of a large hedge fund firm called Galleon Group.  (In hindsight, the pirate-looking ship photos on their web site might have been a clue something was up.)  He was recently listed in Forbes magazine as the 559th richest person in the world with a net worth of $1.3 billion.  He is charged along with several others, including executives at Intel, IBM and McKinsey & Company.

I realize the wheels of justice turn slowly.  However the fact that the SEC has been wiretapping Rajaratnam’s cell phone since March 2008 and has only just now arrested him makes me wonder what they’ve been doing all this time.  I also wonder why someone who is already a billionaire would get involved in a criminal scheme worth only $20 million.

Meanwhile, on a surely unrelated note, the SEC has hired a 29-year-old former Goldman Sachs employee to be the Chief Operating Officer of its Enforcement division.  According to a Bloomberg story, Adam Storch will be charged with making the unit more efficient.

Some will decry the ever-revolving door between Washington and Goldman Sachs, but I will give Mr. Storch the benefit of the doubt along with this suggestion:  When one of your staff attorneys investigates Bernie Madoff and finds nothing wrong, don’t give her the highest possible performance rating and don’t promote her to New York branch chief.  Neither act made the SEC’s enforcement efforts any more efficient.

Today the Labor Department reported that the Consumer Price Index rose 0.2% in September and fell -1.3% in the last twelve months.  This was no great surprise, since it was the seventh consecutive month of negative year-over-year CPI.  September is a special month, however, because it is the end of the federal government’s fiscal year and is used to determine inflation adjustments for the next year.

By law, Social Security payments cannot go down – but they don’t have to go up, and this year they won’t.  This may come as a surprise to retirees who have grown accustomed to getting a “raise” each year.  The last year without a COLA was 1975.

Even more aggravating, health care was one of the few CPI categories to actually go up in the last year while much of the decline was related to energy costs.  Retired people, of course, are often above-average consumers of health care and below-average consumers of energy.  Their cost of living hasn’t dropped, negative CPI notwithstanding.

President Obama and members of Congress are keenly aware that senior citizens won’t like this development at all.  They are therefore seeking to defuse the political explosive environment with a one-time $250 payment to all Social Security recipients.  This would be in addition to the $250 “economic stimulus” payments sent to the same group earlier this year.

These payments will largely offset the lack of a Social Security COLA this year, and some seniors may actually come out ahead.  Nonetheless, at least one lobbying group is already whining that it’s not enough.  The younger workers who pay the bills are, apparently, not their concern.

With many new media (blogs, twitter, content aggregation sites) outlets operating in unregulated wild frontier mode, the FTC saw fit to try to restore some sense of order. FTC 16 CFR Part 255 says that effective December 1, those that review products must disclose any connection with advertisers.

This has been a long standing policy with many in the financial world. For example, Seeking Alpha requires that contributors with Gold Standard Certification “… must disclose if they are employed by a company whose stock they are writing about; perform consulting for a company they write about; receive paid advertising revenue or any other form of sponsorship fee from a company they write about.” However, this policy is “self-enforced by contributors” and Seeking Alpha does not have any mechanism to ensure contributors are making such disclosures. Nor is there any penalty for failing to do so, other than having future contributions potentially rejected by Seeking Alpha.

I have yet to see a financial website article or blog post disclose the receipt of advertising revenue from the firms behind the products they are writing about. To me, this is a blatant conflict of interest. I’d like to think that somebody, somewhere has done it, but to my knowledge, no author/contributor has ever disclosed the receipt of advertising revenue (either directly or indirectly) from iShares, WisdomTree, or other ETF sponsors when writing a review of one of those products.

Perhaps this will change on December 1. In the mean time, everyone should be aware that proper disclosures are not being made and those glowing reviews may not be truly independent.

Disclosure (as required by FTC 16 CFR Part 255): I have no positions in any individual securities mentioned. I have no positions in any of the companies or ETF sponsors mentioned. I have never received any income, revenue, or fees from, or on behalf of, any of the companies or ETF sponsors mentioned.

According to data published in USA Today, the government gave a total of $365 billion to 700 different banks under the TARP program.  The Treasury received preferrred stock from these banks which is supposed to pay a quarterly dividend.   Now we learn that 33 of these banks simply decided not to pay dividends this quarter.  American International Group (AIG), which also received TARP money but is not technically a bank, also failed to pay its dividend.

A Treasury spokesperson claims that the banks are contractually permitted to skip these payments – and of course the federal government respects their rights.  This is laughable.  The federal government is probably the least contract-respecting institution in the world today.   The rights that need to be respected are those of the taxpayers whose capital is being used to prop up institutions that would otherwise have collapsed. 

Why are these institutions stiffing us?  From their point of view, why not?  They were handed free cash at a time when their very existence was being threatened.  Of course they took it.  Maybe now their existence is threatened again due to loan losses and they need to conserve cash.  Or maybe they would just rather use the TARP money for other things.  We don’t know.  What we do know is that the odds the government will  make a “profit” from TARP are not high.

AIG alone owes the Treasury $69.8 billion, according to Reuters.  The automotive industry owes $80 billion.  The 600 banks that haven’t yet repaid their TARP money owe a total of $134 billion.  I, for one, feel sure that the AIG and automotive “investments” will be near-total losses.  One of the dividend-skippers is CIT Group (CIT), which owes $2.3 billion and is probably going to file bankruptcy soon.   This will wipe out preferred shareholders like TARP. 

None of these numbers include the various other bail-out programs and Federal Reserve lending facilities.   The bottom line is that billions (and probably trillions of dollars) have been transferred from the public to politically favored industries like banks.  Most of it is probably never coming back.  A shocking number of people appear to be okay with this.  They say it is distasteful but necessary to save our capitalist system.

No, no, no.  This is not capitalism.  If it were capitalism, incompetent and unprofitable businesses would cease to exist.  Their directors, managers and employees would lose their jobs.  Investors would lose their investments.   This is what happens in industries that lack the ability to extract capital from the public with the government as intermediary/collection agency.  Call it whatever you like, but it’s not capitalism.

The final insult: if you happen to owe money to one of these deadbeat banks, do you get the right to skip payments?  Does your lender simply shrug and tell you to pay when you feel like it?  I didn’t think so.

The G-20 promotes global cooperation between the largest economies in the world. Although decisions are officially non-binding on the member states, members consult each other on major economic decisions. The group has loose ties to the World Bank, the International Monetary and Finance Committee, the Financial Stability Forum, and other international institutions.

G-20 economies comprise 85% of global production, 80% of world trade, and two-thirds of the world’s population. Current member states are Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, United Kingdom, United States, and the European Union.

One of the more significant results of the Pittsburgh meeting was the announcement that the G-8 is no longer the primary international economic forum. On Friday, G-20 leaders declared the G-8 has been superseded by the G-20 as the main economic council of wealthy nations. This illustrates the ascent of emerging markets. China will soon overtake Japan as the world’s 2^nd largest economy while Russia, Brazil, India, and other ‘2^nd tier’ economies are growing quickly.

Another event relates to a two-word declaration in the event’s final statement. Speaking on the global financial crisis and how the G-20 responded to it, leaders inserted a blunt “it worked.” They may have spoken too soon. Continued high unemployment, banking sector instability, and the injection of trillions in economic stimulus into the global economy could create more problems.  Of their seemingly premature conclusion, one former chief economist of the International Monetary Fund said, “it’s hubris.”

Finally, the G-20 wanted to be seen as moving past the global recession. They addressed global climate change. President Obama spoke about a “transition to a 21st-century clean energy economy.” No timetables were set and no decisions made. However, the fact that G-20 leaders addressed the topic underscored current momentum for action on cap-and-trade, carbon restrictions, and other green initiatives. Worldwide action on these goals, for better or worse, is gaining momentum

In reading the UNG 8-K filing, the fund makes no promise to resume share creation.  In fact, it spells out four conditions where new share creation may take place:

1. At its sole discretion, UNG may accept “specified  investments that meet UNG’s investment objective”  from Authorized Participants in exchange for newly created shares.  The “specified investments” are to be an over-the-counter swap contract between UNG and the Authorized Participant.
2. UNG’s management may decide to limit the number of new shares to any single Authorized Participant.
3. UNG’s management may vary the terms and conditions of the investments to be delivered.
4. UNG’s management may decide to offer new shares only on particular days.

The core of the filing is the first condition listed above.  Namely, UNG intends to circumvent exchange-imposed position limits by having the Authorized Participants be responsible for hedging their positions with futures contracts.  The use of swaps relieves UNG from the need to buy additional natural gas contracts while causing Authorized Participants to shoulder that burden.

UNG also makes two new disclosures that investors should be aware of.  First is that UNG’s expenses are expected to increase with these proposed swap arrangements and therefore the fund’s expense ratio will likely increase, as will its tracking error.

The second disclosure involves UNG’s current premium and is repeated here:

“At present, UNG’s units are trading at a premium to its net asset value (“NAV”).  UNG’s management cannot predict what impact, if any, the resumption of creation activity will have on the price of the UNG units on NYSE Arca.  It is possible that the resumption of creation activity, even on a limited basis, could reduce or remove any premium over NAV.  Investors are cautioned that paying a premium over the NAV for UNG units can lead to additional losses for the investor in the event that the investor sells such units at a time when the premium is no longer present in the market price.”

Investors should be aware that this filing may also reduce the premium.  The premium is constantly changing.  Around an hour before the close today, UNG was trading at $10.94 while its underlying value was $10.32, a premium of about 6%.  At the same time, competitor iPath DJ-UBS Natural Gas Total Return ETN (GAZ), another fund that has halted share creation, was trading at an 11% premium (price of $15.18 and underlying value of $13.67).

Links to UNG website and GAZ website.

Disclosure: no positions

Unlike many other ETF and ETN closures that result from the failure of the products to gain traction in the market, DXO has attracted more than $600 million in assets since its launch in June 2008.  In fact, it may have become too successful.

Deutsche Bank did not directly mention the CFTC in its announcement but said this redemption is the result of “limitations imposed by the exchange” causing a “regulatory event” as defined in the terms of the Notes.  Exchange-traded notes (ETNs) are different than typical ETFs, but that does not appear to be a root-cause of this closure.  See our open letter to ETN sponsors and our article on ETN risk for additional information.

Daily share creations of DXO have been suspended, and it closed today at a 4.5% premium to its underlying value.  Additional information can be found on the PowerShares ETN website, including the prospectus for the DXO Notes.

No other DB ETNs are affected at this time, including PowerShares DB Crude Oil Long ETN (OLO), PowerShares DB Crude Oil Short ETN (SZO), and PowerShares DB Crude Oil Double Short ETN (DTO).  DTO was the best new exchange-traded product of 2008.

Disclosure: no positions

As the name implies, the CFTC regulates commodity futures. One of its tasks is to keep speculators from cornering the market or manipulating the price of agricultural products like grains. They do this through a system of “position limits”, which prohibit investors from controlling more than defined quantities of these contracts.

The position limits are normally of no concern to individual investors, even those who trade commodities, because it takes a lot of capital to exceed them. If, however, you are an investment manager who wants to combine the money of many investors into one large pool, the limits can be a problem.

In 2006 DB Commodity Services, a subsidiary of Deutsche Bank, wanted to launch several commodity-based ETFs. Realizing that the CFTC position limits would constrain the asset size to which these ETFs could grow, DB asked for and received from the CFTC an exemption from the position limits.

All was fine; PowerShares DB Agriculture Fund (DBA) and PowerShares DB Commodity Index Tracking Fund (DBC) went forward with great success. Then this week the CFTC revoked the previous exemption, leaving the future of DBA, DBC, and similar funds in doubt.

Why, one might ask, does the CFTC feel compelled to reverse itself in this way? In a press release, CFTC chairman Gary Gensler said “I believe that position limits should be consistently applied and vigorously enforced… Position limits promote market integrity by guarding against concentrated positions.”

This sounds very noble of Mr. Gensler, but I believe he is mistaken. Funds like DBA and DBC actually give the commodity markets even more integrity by making them accessible to small investors. Because the funds simply track indexes, the potential for manipulation is negligible. The funds do not act as one large investor accumulating a large concentrated position, they are the collective actions of many small investors.

Over at Seeking Alpha, David Fry suggests there may be more going on here than concern for market integrity. Mr. Gensler was also a Treasury Department official in the Clinton administration. He advocated legislation that prevented the CFTC from regulating credit default swaps and other derivatives that are now blamed for aggravating the financial crisis.

Goldman Sachs (GS), a firm at which Mr. Gensler worked for 18 years, is a major player in these instruments that he once wanted to protect from excessive regulations. Why he has since changed his tune is unclear. In any case, investors who want to participate in commodity markets via ETFs are not being well served by the CFTC. I hope this is not a sign of things to come.

The CFTC’s words and actions have already scared two other funds to the point where they are no longer issuing new shares, making them de-facto closed-end funds in the process. U.S. Natural Gas Fund (UNG) has not been issuing new shares since early July and is trading today at 16% premium. Early today, Barclays issued a press release stating that iPath Dow Jones – UBS Natural Gas Total Return ETN (GAZ) has stopped issuing new shares. It is now trading at a 7% premium.

Patrick Watson contributed to this article.

Disclosure: no positions

In June, FINRA issued a warning to brokers and investment advisors regarding leveraged and inverse ETFs.   We predicted at the time that brokerage firms would likely place some restrictions, but we never envisioned a total ban.  We reported the release from FINRA contained something that ought to put a chill up the spine of leveraged ETF marketing executives: “…inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”  This is legal-speak for “Don’t sell these to anybody except day traders.”

By July it was apparent that the FINRA warning had a greater impact on the legal departments of the brokerage houses that sold these products than on the leveraged ETF marketing executives.  After all, the ETF sponsors have long warned of the dangers that can come from misusing these products and all provide warnings and educational material.  Here are links to such information for DirexionShares, ProShares, and RydexShares.

Edward Jones was the first to ban/cut leveraged ETFs from their lineup according to a July 21 article in the Wall Street Journal.  Next came reports that LPL Financial, Ameriprise Financial, and UBS were also banning the products.

I’m not sure what their real motives are, but the actions taken by these brokers seem insincere.  Here are some of the reasons why I feel this way:

1. Funds that use a “daily reset” of their leverage and inverse exposure are nothing new.  The first leveraged fund was Rydex Nova (RYNVX), launched in July 1993 (16 years ago).  Rydex Ursa (RYURX), the first inverse fund, came out six months later in January 1994 (note: Ursa has since been renamed Rydex Inverse S&P 500 Strategy).
2. In late 1997, ProFunds introduced 2x long and 2x inverse funds that reset their target exposure on a daily basis.  This was nearly a dozen years ago.  Leveraged and leveraged inverse funds are nothing new.
3. The math has not changed.  The mathematics were the same in September 1994 when RYNVX and RYURX were both showing year to date losses.  The mathematics were the same in the early part of this decade when 2x long ProFunds Ultra Nasdaq 100 (UOPIX) and 2x inverse ProFunds UltraShort Nasdaq-100 (USPIX) both had double digit losses while the underlying index had a gain.
4. Many, if not most, of the brokers that have banned leveraged and inverse ETFs still offer leveraged and inverse mutual funds.  When it comes to daily reset of leveraged and inverse exposure, there is no difference between ETFs and mutual funds.
5. Many, if not most, of the brokers that have banned leveraged and inverse ETFs still offer put and call options to their clients.  It is a well known fact that many options expire worthless and investors lose 100% of their investment (plus commissions).  To my knowledge, no leveraged or inverse ETF has ever lost 100% of its value.  Options are more risky than leveraged ETFs.
6. Many, if not most, of the brokers that have banned leveraged and inverse ETFs still offer short selling to their clients.  It is a well known fact that short-selling is risky and the potential loss can be well in excess of your entire investment.  With inverse ETFs, your risk is limited because no ETF has ever lost 100% of its value.  Short selling is more risky than leveraged ETFs.
7. Many, if not most, of the brokers that have banned leveraged and inverse ETFs still offer margin accounts to their clients.  It is a well known fact that margin accounts are risky and the potential loss can be in excess of your entire investment.  The value of your leveraged and inverse ETFs should never decline by more than your investment.  Margin accounts are more risky than leveraged ETFs.

The fact is that the “daily reset” of leverage actually protects investors from blowing themselves up.  It prevents a position from going to zero, it prevents margin calls, and it prevents the unlimited loss potential of short-selling.

These products should not be banned.  They should be hailed as great achievements in risk management.  They are actually protecting investors from themselves.

Disclosure:  I currently own a few leveraged and inverse products.  I have been using them since 1994, and they have always performed as stated in the prospectus.

UPRO and SPXU are clearly intended as a counter to the very successful DirexionShares 3x ETFs. ProShares may have a slight advantage with these ETFs as they are benchmarked to the more familiar S&P 500 index. Direxion’s 3x Large Cap funds, Daily Large Cap Bull 3x Shares (BGU) and Daily Large Cap Bear 3x Shares (BGZ), are tied to the Russell 1000 Index, which includes many stocks that are considered mid cap or even small cap in the S&P scheme.

The providers of leveraged ETFs are coming under more and more scrutiny as investors discover – and all too frequently misuse – these products. This month the Financial Industry Regulatory Authority (FINRA) reminded brokers of their obligation to make sure customers are fully prepared for the risks of leveraged ETFs. Despite abundant disclosure, people still have a hard time grasping that positions in these ETFs will not receive the stated 2x or 3x leverage if they are held for more than one day.

The release from FINRA contains something that ought to put a chill up the spine of leveraged ETF marketing executives: “…inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.” This is legal-speak for “Don’t sell these to anybody except day traders.”

Don’t be surprised to see brokerage firms place restrictions on who is allowed to trade these ETFs and under what conditions. The potential for large losses in a short time is significant, and brokers do not like dealing with unhappy customers – not to mention that the losses could result in your account balance with them dwindling in the future.

For its part, ProShares is trying to distinguish between its 2x and 3x products by adding an extra “Pro” to the otherwise very similar names. ProShares Ultra S&P 500 (SSO) is 2x, while ProShares UltraPro S&P 500 (UPRO) is the new 3x product. Not exactly crystal-clear but hopefully good enough.

ProShares now offers 86 leveraged and inverse ETFs. We are not sure what will come next, but the race for ETF product innovation is far from over. ProShares wins today’s battle.

Disclosure: no positions