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Investors Flunk “Too Good To Be True” Test Again

“You only find out who is swimming naked when the tide goes out.” - Warren Buffett

The tide has been going out for several years now and we are discovering that many of the biggest players never owned bathing attire. Tight credit and massive erosion in asset values have exposed the mismanaged or fraudulently run operations that previously papered over their flaws with more credit. Investors in Stanford Financial, who apparently ignored the common sense rule of “if it’s too good to be true it’s probably not” are likely to be in for a massive shock of reality this week.

According to BusinessWeek, The Stanford Group may hold as much as $50 billion in assets.

Is Stanford’s Financial Offer To Good To Be True?

Financier R. Allen Stanford makes investors an enticing offer: He sells supposedly super-safe certificates of deposit with interest rates more than twice the market average. His firm says it generates the impressive returns by investing the CD money largely in corporate stocks, real estate, hedge funds, and precious metals.

But skeptical federal and state regulators are now taking a hard look at Stanford’s operation—especially those CDs, whose underlying investments seem questionable. Over the past 12 months, the stock market and hedge funds have lost huge amounts of value even as Houston-based Stanford Financial Group continued to pay out above-average returns and claimed to have boosted the assets it oversees by 30%, to more than $50 billion.

BusinessWeek has learned that the Securities & Exchange Commission, the Florida Office of Financial Regulation, and the Financial Industry Regulatory Authority, a major private-sector oversight body, are all investigating Stanford Financial. The probes focus on the high-yield CDs and the investment strategy behind them. According to people close to the investigations, the three agencies are also looking at how Stanford Financial could afford to give employees large bonuses, luxury cars, and expensive vacations. Selling CDs typically is a low-margin business.

Jittery

In the wake of Bernard Madoff’s alleged $50 billion Ponzi scheme, regulators and investors around the world are increasingly jittery about money-management firms that promise consistently higher-than-normal returns.

Stanford’s CDs, which require a minimum investment of $50,000, offer tantalizing interest rates. The current rate on a one-year CD is roughly 4.5%, according to the bank’s Web site. The average at U.S. banks is about 2%, notes research firm Bankrate.com ((RATE)). A year ago, the offshore bank sold five-year CDs that yielded 7.03%; the industry average hovered around 3.9%.

The firm suggests in marketing material that it can offer substantially higher rates because the bank benefits from Antigua’s low taxes and modest overhead costs, among other factors. The bank invests in a “well-diversified portfolio of highly marketable securities issued by stable governments, strong multinational companies, and major international banks,” the marketing literature says.

But Stanford Financial and its affiliated bank, both of which are owned by Allen Stanford, offer few details about the nature of those holdings. According to the bank’s 2007 annual report, stocks, precious metals, and alternative investments—such as hedge funds and real estate—account for 75% of the bank’s portfolio.

Stanford’s CDs lack the government insurance that backs certificates issued by U.S. banks.

The financials of the offshore bank are audited by a tiny accounting firm (14 employees) in Antigua called C.A.S. Hewlett & Co.

The offshore bank’s seven-member board of directors is dominated by Stanford insiders, family, and friends.

Stanford brokers who sold at least $2 million of CDs in a quarter kept 2% of the assets, says Hazlett. That’s much more than competitors generally pay their sales forces on such investments. “The primary thing they cared about were CDs,” says Hazlett. “That was all they talked about in meetings with brokers.” But the high yields “never made any sense to me,” he adds. “I never understood how they could generate the performance to justify those rates.”

Funding Commitments Pulled, CD Redemptions Delayed, Assets Invested In Illiquid Securities

An offshore bank at the center of two U.S. federal investigations recently curtailed financing commitments to two small American companies, regulatory filings show.

Some Stanford International representatives have been recently advising clients that they can’t redeem their CDs for two months, a person familiar with the matter said.

But SEC filings show that the Antigua bank also holds majority stakes in a handful of thinly traded American firms.

Stanford Financial Gets More Scrutiny - FBI and SEC Investigate

An investigation into wealthy financier R. Allen Stanford’s operations is intensifying, with the FBI looking into his financial group in the U.S. and regulators in Antigua scheduled to visit his bank there.

Another person familiar with the investigation said the SEC has been looking at the certificate-of-deposit business since at least 2007.

Those people say the agencies now are focusing on certificates of deposit, which are marketed by the financial group’s wealth-management arm and sold by Mr. Stanford’s Antiguan bank. The CDs offer unusually high returns; for example, as of Nov. 28, a one-year, $100,000 CD paid 4.5%.

“The first thing that grabs your eye is the business model,” says Alex Dalmady, an analyst who unveiled concerns about Stanford International Bank in the magazine VenEconomy Monthly but isn’t involved in the investigation. “Taking deposits and playing the stock market — this is way too risky. “

Stanford Blames “Disgruntled Workers”

Feb. 13 (Bloomberg) — R. Allen Stanford, the billionaire chairman of Houston-based investment firm Stanford Group Co., blamed “former disgruntled employees” for stoking regulatory probes into his firm.

Stanford Group pushed its financial advisers to steer clients’ money into the offshore CDs, paying a 1 percent bonus commission and offering prizes including trips and cash for the best producers, according to four former advisers who asked not to be identified.

Marketing material for Stanford Group CDs raised red flags, said Bob Parrish, a financial planner and accountant in Longboat Key, Florida.

The use of the term “CD” to describe the investment was misleading because most investors associate it with a safe, FDIC- insured instrument, Parrish said.

SIB describes the CDs in its disclosure statement as traditional bank deposits. The bank doesn’t lend proceeds and instead invests in a mix of equities, metals, currencies and derivatives, according to its Web site and CD disclosures.

Warning Signs Ignored By All

Yields offered at twice the market average, offshore accounts, huge commissions paid to brokers to draw in more cash, SEC investigation since 2007, extravagant corporate lifestyles, assets invested in hedge funds, real estate, stocks and alternative (illiquid) investments which have all fallen 40 - 50% in value, frantic efforts to raise additional funds, previous regulatory investigations and risky business model. It is not hard to see the ending to this story. Once again regulators and investors have shown extraordinary carelessness and disregard of information that was readily available for scrutiny.

This is probably not another Ponzi scheme similar to Bernard Madoff. It seems more like a case of poor asset management leading to large losses which management then attempted to cover up with additional investor funding. The end result, however, will be the same as for those who invested with Madoff - a significant loss on their investments.

Stock position: None.

Source: Stanford Financial Is Next Hedge Fund Investigated