Monthly Archives: May 2009

Facing hundreds of arbitration claims and class-action lawsuits over huge losses in two ultra-short bond funds known as the Schwab YieldPlus Fund (SWYPX) and the Schwab YieldPlus Select Fund (SWYSX), Charles Schwab & Co. may want to rethink its “Talk to Chuck” advertising slogan. The funds have become a financial disaster for investors, who say the San Francisco-based investment firm marketed and sold the YieldPlus funds as relatively conservative investments whose risk levels were on par to that of money-market funds.

Instead, the funds (collectively referred to as the Schwab YieldPlus Fund) were over-concentrated in high-risk, illiquid mortgage-backed securities. Following the collapse of the subprime mortgage market, this overconcentration in speculative investments resulted in massive losses of more than $1.3 billion. In total, the Schwab YieldPlus Fund lost a staggering 33.7% of its value last year. By comparison, the average ultra-short bond fund fell 1.9%.

To no one’s surprise, the Schwab YieldPlus Fund ranked dead last out of 50 ultra-short bond funds tracked by Morningstar, Inc. in 2008.

YieldPlus investors across the country have since filed hundreds of arbitration complaints with the Financial Industry Regulatory Authority against Charles Schwab, charging the company of intentionally withholding important details about the portfolio diversification of the Schwab YieldPlus Fund and the fact that a large portion of the fund’s assets had been placed in high-risk subprime mortgage holdings.

Investors also claim Charles Schwab created misleading marketing materials to falsely tout the supposed investing safety of the YieldPlus Fund – information that was reiterated in public statements made fund managers.  Financial prospectuses give further credence to investors’ claims, with information stating the fund’s investing objective as one of seeking high current income with minimal changes in share price. 

FINRA arbitration panels continue to review claims against Charles Schwab for investors’ losses in the Schwab YieldPlus Fund. In one decision, FINRA awarded more than $500,000, or about 81%, of the investor’s claimed damages. Other FINRA claims have yielded awards totaling 100% of the damages claimed by investors.

Credit default swaps (CDS) may be described as insurance-like contracts designed to hedge against default on loans or bonds, but they are far from ordinary insurance. Created in the early 1990s by JPMorgan Chase & Co., credit default swaps belong in a derivatives class all by themselves. Some call them ticking bombs; others – most notably billionaire investor Warren Buffett – refer to credit default swaps as financial weapons of mass destruction, carrying dangers that are potentially lethal and deadly.

Now matter how you characterize them, most financial experts now agree that credit default swaps are, in large, responsible for the upheaval in the stock and credit markets and the resulting financial crisis happening around the world.

A credit default swap essentially is an obscure and complex derivative instrument that takes the form of a private contract between a buyer and a seller. The buyer (investor) of a credit default swap pays an upfront fee plus annual premiums to a seller, which typically is a bank or hedge fund, to cover potential loss on the investment outlined in the contract.

The underlying caveat to a credit default swap is the counterparty risk involved in the contract. The credit default swaps market – estimated at $62 trillion in 2007 – is unregulated, with swaps sold over the counter. With no regulation, there’s no entity overseeing the trades to ensure a purchaser of a credit default swap has the financial resources to make good on a swaps contract if it is called in.

Think Bear Stearns. American International Group (AIG). Lehman Brothers Holdings. Lehman Brothers was deeply entrenched in the credit default swaps market. When the company filed for bankruptcy on Sept. 15, 2008, sellers of its credit default swaps contracts found themselves on the hook for billions and billions of dollars.

As for AIG, its involvement in credit-default swaps reportedly pushed the financially troubled firm to the brink of bankruptcy in September before the federal government stepped in with a bailout that now totals more than $182 billion.

And then there’s Bear Stearns. It, too, became crushed under the weight credit default swaps. Its fate was finally sealed when JP Morgan – ironically the inventor of the derivative instruments – purchased the 85-year-old investment firm in March 2008 for the fire-sale price of $2 a share. Under pressure from shareholders, the deal was later revised to $10 a share.