The so-called municipal bond "arbitrage" strategy was a very complex investment strategy involving multiple investments in the tax exempt and taxable fixed income markets. The fund managers invested in long tax exempt municipal bonds and, in effect, shorted the equivalent of taxable corporate bonds utilizing libor swap contracts and swaptions. The key to the success of the strategy was "market timing" and the "continued correlation" of the tax exempt municipal bond yields and the libor swap contract yields. It was originally used by many banks as a short term trading strategy. But many firms like Aravali Partners converted it to a flawed long term buy and hold strategy to maximize their own sales commissions and management fees.
In August 2007, the handwriting was on the wall for the "muni-arbitrage" funds. It was time to sell not buy. It was not the time to launch new funds or increase the leverage of the funds. The "continued correlation" of the tax-exempt and taxable fixed income market yields had collapsed. The lack of correlation and the high leverage was a recipe for disaster. Nevertheless the "muni-arbitrage" fund managers proceeded with the investment strategy full steam in derogation of their fiduciary duties to investors.
Alex Brown Deutsche Bank blamed the unforeseen and unprecedented market conditions as the reason for the collapse of the so-called "muni-arbitrage" funds in 2008. Nothing could be further from the truth, the funds were rocked in August 2007 and fund managers were put on clear notice of the dangerous market conditions and risk of loss. The real cause of the collapse was the fund managers' reckless disregard of the key factors of the strategy, "correlation" and "market timing," in relation to market conditions. As a result, many investors have commenced arbitration proceedings and recovered their losses due to misrepresentations and mismanagement of the so-called muni-arbitrage funds.
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