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Municipal Arbitrage Losses in 1861 Capital Management

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.

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

1861 Capital Discovery Domestic Fund, LP was marketed and sold by UBS and other broker dealers as a safe, secure, and low-risk municipal bond portfolio complement. In truth, however, 1861 was a fund, better described as a leveraged municipal arbitrage fund. The 1861 fund was organized as a Delaware partnership whose purpose and investment strategy is to generate attractive returns through trading in municipal bonds, and in residual certificates of tender option bond trusts backed by municipal bonds along with the use of hedging strategies.

The 1861 strategy sought to arbitrage the spread between yields on municipal bonds and other types of debt investments such as treasuries and LIBOR swaps.

In marketing 1861 to investors, UBS targeted high net worth individual investors who were generally risk averse, took a conservative approach to investing and were interested in the safety and security offered by tax free municipal bonds.

The municipal arbitrage strategy employed by 1861 was risky and exposed investors to a 100 percent or more loss of principal, was more than 2 times more volatile than the S&P 500 and 7 times more volatile than a traditional portfolio of municipal bonds. The municipal arbitrage strategy was inconsistent with the promises made to clients about the safety and security of tax free income.

For more information on municipal arbitrage strategies: