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Home > Cases > 1861 Capital Management > 1861 Capital Management Suffers Under Leveraged Municipal Bond Arbitrage Strategy

1861 Capital Management Suffers Under Leveraged Municipal Bond Arbitrage Strategy

The hedge-fund community is in survival mode these days, reeling from the subprime fallout and an overall lack of investor confidence in Wall Street. For some troubled hedge funds, including Citigroup's ASTA/MAT, 1861 Capital Management, Blue River Asset Management, GEM Capital and Rockwater Hedge Fund, LLC, the culprit behind their financial woes is the investing strategy itself: leveraged municipal bond arbitrage.

A new study released by the Securities Litigation and Consulting Group (SLCG) sheds new light on the added risks involved in leveraged municipal bond arbitrage and how the end result can mean devastating financial losses for unsuspecting investors.

As reported in a Feb. 29, 2008, article by MarketWatch, firms like 1861 Capital Management that focus on municipal arbitrage try to take advantage of differences between municipal bonds and other types of debt, including Treasury securities and corporate bonds. The concept of municipal arbitrage is to buy higher yielding, long-term municipal bonds. These bonds are then sliced up into short-term municipals called “tender option bonds” (TOBs), which, in turn, are sold to investors. Because TOBs have lower yields, hedge funds make their money on the difference between the long-term and short-term municipal yields.

Municipal arbitrage hedge funds also can be highly leveraged. And with leverage comes added risk - something investors may be woefully unaware of.

According to SLCG's study, hedge funds like 1861 Capital Management and ASTA/MAT were marketed by many brokers to investors as high-yield, more conservative alternatives to money-market fund or traditional municipal bonds. In reality, this was far from the truth. Not only is leveraged municipal bond arbitrage at the opposite end of conservative, but it also can produce lower-than-expected returns for investors and bring considerably more risk.

Findings from the SLCG study show that the leveraged municipal bond arbitrage strategy used by 1861 Capital Management, ASTA/MAT and others was based on a flawed concept of market inefficiency and a “tenuous arbitrage opportunity.” In other words, the hedge funds that used the strategy introduced additional risk by leveraging in order to generate gross returns from the perceived arbitrage opportunity to cover bankers' fees and to net a marketable return to investors.

The SLCG study also shows that much of the losses suffered by investors in these hedge funds occurred during a period of relatively routine interest rates and not during an unprecedented interest rate environment.

Collectively, the investors in the hedge funds featured in SLCG's study have lost millions and millions of dollars. Now, many of these same investors are saying that certain aspects of the hedge funds were misrepresented, especially the risk factors of their investment.

In addition to disclosure issues, investors also contend that the hedge funds in SLCG's study instituted what's known as a “gate provision,” which essentially restricts investor withdrawals. This, in turn, left investors unable to access to their money, despite the fact that the funds turned out to be riskier than they ever expected or wanted. Had investors known about this policy, they could have made their exit long before a financial tsunami did it for them.

Our affiliation of securities lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage-related investment losses.


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