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Sub-Prime, So Over! Part II

Can't spot the patsy? Then it might be you – or your mutual fund, local government officers or money-market managers...

ON AUGUST 8 2007, just one day before the "credit crunch" struck – "an accident waiting to happen" as Alan Greenspan recently put it – the Investment Council of Oregon met and voted to change the way it invests the state's public retirement funds.

   "Members of the council and staff from the state Treasury voted to gradually sell billions of dollars' worth of US stocks," reported The Oregonian newspaper the following morning, right around the time the S&P index was beginning its 3% plunge for the day.

   The State Investment Council's plan? To "reinvest the proceeds in somewhat riskier real estate, private equity and international securities."

   Fair's fair. US stocks promptly took a tumble – and the State Treasury had said all along that in 2007 it wanted to "broaden [the] investment universe" for its real estate and alternative plays.

   But even after voting this summer – and voting unanimously – to put $150 million into the Rockpoint Real Estate a $200 million commitment to Blackstone Real Estate...and another $125 million into the Fortress Fund V (targeting "a broad range of real estate and other asset-backed investments using 65% leverage")...the State of Oregon was still late to the party in mortgage-backed investments.

   By the start of June, reports Bloomberg:

  • the General Retirement System of Detroit held nearly $39 million in the highest-risk portions of three subprime-backed bonds;
  • the Teachers Retirement System of Texas owned $62.8 million of these subprime "equity" tranches ("equity" being the banking world's jargon for "highest risk, most likely to default");
  • the Missouri State Employees' Retirement System held another $25 million;
  • the New Mexico State Investment Council owned more than $222 million of these high-risk products.

   No doubt there's more public money in subprime "equity" tranches, too. Indeed, the New Mexico State Investment Council opted as recently as April '07 to buy another $300 million in subprime "equity" according to David Evans in his June 1st feature for Bloomberg.

   That would have taken high-risk mortgage debt to nearly 3.5% of its total pot!

   But US state pension funds weren't the only professional money-managers piling into those mortgage-bonds most likely to go bust. Buying subprime exposure has been a crowded trade – and you may well be long of "toxic waste" as a result.

   Everyone else is, it seems, whether they chose to be or not!

1. Money Market Funds
By the start of Sept. '07, new cashflows into US money-market funds had outstripped 2006 inflows for the same period more than three times over says data from the Investment Company Institute.

   US equity funds, on the other hand, saw net inflows drop by one-quarter.

   Money-market funds only grew more attractive to safety-seeking investors as the threat of recession, inflation or some kind of financial meltdown (if not in fact all three at once) became obvious to anyone watching the evening news in spring 2007.

   But while fund buyers missed out on a near-8% gain in the S&P between Jan. and Sept., at least they could be sure they were also cutting out risk. After all, money market funds are designed to offer "immediate liquidity, safety and a reasonable rate of return" says Bruce Bent, founder of the first money-market offering – the Reserve Fund – some 35 years ago.

   Subprime mortgage debt "doesn't have a place in money market funds," Bent told Bloomberg recently, adding that "it's inappropriate."

   But in a world of sub-5% yields, which is what money managers have endured since the US recession of 2001, "inappropriate" doesn't mean you don't buy it.

   "US money market funds have invested $11 billion in subprime debt," writes David Evans in the latest issue of Bloomberg Markets. Paper debt "laced with subprime home loan securitizations" accounted for more than 5% of Wells Fargo's Advantage Money Market Fund in June; Credit Suisse's Prime Portfolio had 8% of its assets exposed to subprime mortgages; two funds run by A.I.M. held $2.64 billion in collateralized debt, much of it based on subprime mortgages.

   "I don't think the typical money market investor in his wildest dreams would assume he has exposure to the risk of subprime CDOs [collateralized debt obligations]," says Satyajit Das, formerly a banker at Citigroup and a leading authority – as well as former exponent – of today's most exotic haute finance offerings.

   Take, if you will, the PayPal money-market for example. It's run on behalf of Ebay, the online auction phenomenon, and stands at "No. 2 among 248 first-tier retail funds over the past five years," according to Reuters.

   PayPal's money market fund invests all of its current $1 billion holdings into a "master fund" run by Barclays, the third-largest bank in London. No prizes for guessing what Barclays "master fund" is exposed to, starting with the "special investment vehicles" (SIVs) that investment banks have used to fund and expand the subprime-mortgage bond market.

   The performance of PayPal's money market fund, says Reuters, has matched Barclays master fund tick-for-tick. Is that what money-market investors expected?

2. Mutual Funds
If you've got money in a bond fund – and your financial advisor, no doubt, will never tire of saying you should – it may well contain more subprime spice than you might have expected.

   Sure, plenty of fixed-income feasts state their exposure right there on the can: Pimco Total Return Mortgage...Huntington Mortgage Securities...Vanguard GNMA. And if you know what you're eating, at least you'll know who to blame if you feel sick in the morning (meaning you).

   But the difference between cheese-flavor and real cheddar is starting to show up outside the pure mortgage brands, too. "The annual report filed for the Regions Morgan Keegan Select High Income Fund offers a rare window," says Diya Gullapalli for the Wall Street Journal, "into how mutual-fund firms are reporting and valuing their holdings in the wake of this summer's subprime-mortgage crisis."

   Total assets at the High Income fund are down from $1 billion to around $420 million since the start of this year, according to Morningstar data. On a valuation basis, the fund has dropped by around one-third, Gullapalli goes on. But that still includes all the "mark-to-model" work put in by its bean-counters. Prices for some 60% of the High Income's assets had to be based on "fair value" rather than market prices.

   Why? Because, it seems, there simply ain't no market price to quote.

   "The annual report also outlines some important steps taken by the funds' adviser and affiliates to help cope with recent losses," the Journal's sleuth goes on. "These include stepping in to buy about $55.2 million in shares of the High Income Fund and $30 million in [Regions Morgan Keegan's] Intermediate Bond Fund from the beginning of July to the end of August, to help provide liquidity."

   Next time you get hungry for yield – and want a bond fund to sate your cravings – it might be worth checking the ingredients.

3. Private Pension & Insurance Funds
It's an iron law of the universe that investors don't sue if they don't lose any money. Hence the lawsuit now being brought by insurance giant Prudential of the US against State Street, one of the world's largest fund managers.

   State Street Global Advisors stands accused of failing to mention a change in policy that let it put subprime-based derivatives into two "low risk" funds. As a result, says Prudential, it took an $80 million hit in August.

   Poor State Street! The $2 trillion behemoth is also being sued by Unisystems, a New York publishing group, in a class action. Unisystems says that 25 of its employees held $1.4 million in State Street's Intermediate Bond Fund.

   Three of the fund's top ten holdings are mortgage-backed securities, courtesy of Wells Fargo, TBW and Bank of America. Between July and Sept. this year, the suit alleges, the Intermediate Bond Fund dropped by 25%, even as the index it's supposed to track "actually increased".

   Indeed, State Street looks like the proverbial "barn door" right now for lawyers seeking new instructions. The US states of Idaho and Alaska may sue it too, with Alaska's Dept. of Revenue telling the Wall Street Journal that it's considering whether the funds it bought were "more risky than our board had been told about." The Public Employee Retirement System of Idaho, meantime, has got some $570 million in State Street's Intermediate fund.

   "Prudential’s legal action against State Street has a faint echo of Unilever’s negligence action against Merrill Lynch Investment Managers, which led to a [$150m] settlement in 2001," says Renée Schultes at

   "In both actions, the plaintiffs said the managers took risks they should not have done with their money. Both managers had won huge sums of money to manage in previous years."

   How much has been lost – and how much is yet to be lost – by other institutional investors claiming ignorance of what the funds they hired were up to? Just how much cash will now go to lawyers suing one fund on behalf of another, regardless of the original pension-savers' best interests?
4. Public Pension Funds
You might wonder, as several blogs do, quite what the State Investment Council of New Mexico was thinking when it piled up more than $220 million in high-risk real estate bonds?

   Hell's teeth – this thing funds educational services! Don't the bureaucrats in New Mexico know that minors and subprime derivatives don't mix?

   But the fact is, the SIC was only doing the same as everyone else: chasing yield in a world gone mad with cheap money.

   Picture the scene: You used to earn 10% per year for your fund by holding just US government bonds.

   Now you go to work one day...fresh from eating breakfast at the granite-topped plinth in the 250-sq.ft kitchen you managed to nab when you last re-financed and moved find that 10-year Treasuries are paying less than 4%.

   Okay, you kinda knew in the back of your mind that lower rates equaled a bigger house for you and your family. But it also meant miserable returns for your employers – in this case, the would-be pensioners of Oregon State, the teachers of Texas, or the kids of New Mexico.

   What to do? Investment-grade corporate bonds were also paying peanuts, at least compared with a decade before. Between the late '80s and 2003, the yield on mid-risk investment-grade bonds shrank by one-half.

   And even if you tried to make the jump as official Fed interest rates began sinking to their "emergency low" of just 1% in 2002, the extra income you'd earn over Treasury bonds was fast vanishing, too. The "premium" paid by higher-risk company debt was being compressed as the cost of money – and the cost of debt – shrank to record-low levels.

Who Can Blame the Buyers?

   But rat-a-tat-tat! Who's that at the door?

   Oh great! It's an investment-bank salesman, carrying a bundle of AAA-rated home-loans that – he says – are set to pay market-beating returns, secured against the non-stop boom in US real estate.

   And not a moment too soon.

   "We got very interested in [equity tranches] just because a broker brought them to our attention," says Kay Chippeaux, head of the fixed-income portfolio in New Mexico.

   On behalf of the state, her fund bought the highest-risk portions of mortgage-backed bonds from Bear Stearns, Citigroup, Merrill Lynch and Morgan Stanley. (Wachovia also pitched to New Mexico, Chippeaux says. But remarkably, she seems to have turned them away.)

   "We manage risk through who we invest with," she goes on. "I don't have a lot of control over individual pieces of the subprime" – and nor should she, of course. Not for as long as New Mexico's subprime investments don't produce a subprime-sized loss.

   But even a cursory quick glance at history might have advised caution, hesitation, perhaps even a cap on the volume of public funds staked on the banking salesman's latest offers:

  • In 1994, Charles County, Maryland, lost $8.3 billion after putting 98¢ of every Dollar into complex derivatives and collateralized mortgage obligations – the very same CMOs you're reading about in the financial pages 13 years later;
  • Odessa Junior College in Texas lost one-third of its $22 million "investment" in CMOs. Just like the Wall Street bail-out fund now being put together by Bank of America, J.P.Morgan and Citigroup, it tried issuing new debt to cover the losses, but wound up having to slash classes and faculty staff in the aftermath;
  • City Colleges of Chicago bought more than $250 million of mortgage-backed derivatives. The district court eventually awarded it $51 million in damages from Westpac, the salesman;
  • The Shoshone Tribe of the Wind River reservation, Wyoming, lost $3.5 million in the CMO blow-up of 1994;
  • The Lutheran Missouri Synod became a fund advisor in 1990, according to James Bodurtha at Georgetown University, growing its assets-under-management to $900 million by the mid-90s. Mortgage derivatives accounted for some 40% of the foundation's bond portfolio, but they dropped nearly two-thirds of their value by the start of 1999, and the fund closed out at a loss, facing lawsuits from 15 angry Lutherans.

   All this made headlines – big, full-caps, bold-type headlines – less than 15 years ago. Short memories sure help when you've got "innovative" financial products to sell.

   As for the Federal Reserve, it's unlikely to face court as a result of its "emergency" rate cuts of 2001-2003. But if it did, the case might go a little something like this.

Home Ownership Up, Risk Management Down

   The Bush administration, along with every major Western government of the last decade and more, said it wanted home-ownership rates to rise. Here in London, Prime Minister Brown made a "home-owning democracy" one of his key targets – and the magic of mortgage-bond securitization, sparked by the collapse in government bond yields, proved to be just what Washington and Whitehall longed for.

   US home ownership rates rose from 65% to 69% of the population in the 10 years to 2005, says the Atlanta Federal Reserve in a new research paper. The introduction of new mortgage products accounted for perhaps two-thirds of the increase. For the "younger cohort" of new home-buyers, roughly 80% of the 1995-2005 increase came thanks to new mortgage instruments.

   The Atlanta Fed doesn't guess how much of Wall Street's bumper earnings over the last five years came from home-loan innovations as well. But now the US home-ownership rate is falling for the first time in 13 years – and the world's biggest banks have just lost well over $20 billion between them on mortgage-backed investments, too.

   A coincidence? There's more trouble to come judging from Merrill Lynch's latest statement that it's extending its June-Sept. losses by another $2.4 billion, barely three weeks after confessing to a $5.5bn hit.

   Merrill Lynch continues to hold almost $21 billion in subprime and collateralized loan obligations, however. UBS also holds around $20 billion in subprime securities according to Brad Hintz at Sanford C. Bernstein & Co.

   And the rest? Who knows.

   Until the next raft of write-downs show up – and the lawsuits are filed after "unapproved" risks lead to "unexpected" losses – few investors can say with certainty that they're 100% free of subprime.

   That's before doubt and fear infect the wider markets as well, starting with banks and financial stocks.

Adrian Ash

Adrian Ash, BullionVault Gold News

Adrian Ash is director of research at BullionVault, the world-leading physical gold, silver and platinum market for private investors online. Formerly head of editorial at London's top publisher of private-investment advice, he was City correspondent for The Daily Reckoning from 2003 to 2008, and he has now been researching and writing daily analysis of precious metals and the wider financial markets for over 20 years. A frequent guest on BBC radio and television, Adrian is regularly quoted by the Financial Times, MarketWatch and many other respected news outlets, and his views from inside the bullion market have been sought by the Economist magazine, CNBC, Bloomberg, Germany's Handelsblatt and FAZ, plus Italy's Il Sole 24 Ore.

See the full archive of Adrian Ash articles on GoldNews.

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