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October 24, 2007

Sub-Prime? So Over! Part II
by Adrian Ash

"...If you can't spot the patsy then it might just be you - or your retirement-fund manager, money-market fund, local government trustees or mutual fund..."

ON AUGUST 8th THIS YEAR, just one day before the sudden and savage "credit crunch" that Alan Greenspan - former head of the US Federal Reserve - now says was "an accident waiting to happen", the Investment Council of Oregon State voted to change the way it invests 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 the next morning just as the S&P index was beginning its 3% plunge for the day.

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

Fair enough. The State Treasury had said all along that it wanted to "broaden [the] investment universe" for its real estate and alternative plays in 2007.

But even after voting unanimously this summer to put $150 million into the Rockpoint Real Estate Fund...plus a $200 million commitment to Blackstone Real Estate...and another $125 million into the Fortress Fund V, which targets "a broad range of real estate and other asset-backed investments using 65% leverage"...the Oregon Investment Council was still very late to the mortgage-debt party.

By the start of June, the General Retirement System of Detroit held nearly $39 million in the highest-risk portions of three subprime-backed bonds, according to a Bloomberg report.

The Teachers Retirement System of Texas owned $62.8 million of subprime "equity" tranches - "equity" being the banking world's jargon for "highest risk, most likely to never pay up". 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.

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 report 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 alone in piling up those mortgage-bonds most likely to go bust. Buying subprime exposure has been a crowded trade.

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. this year, new cash flows into US money-market funds had outstripped 2006 inflows for the same period more than three times over according to 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 all three at once - became obvious to anyone reading the newspapers in early 2007.

But while fund buyers missed out on near-8% gains in the S&P, at least they could also hope to miss out risk, right? After all, money market funds are designed to offer "immediate liquidity, safety and a reasonable rate of return" according to Bruce Bent, founder of the Reserve Fund 35 years ago.

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

But in a world of sub-5% yields, 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, ex-Citigroup banker and a leading authority - and former exponent - of today's most exotic high-finance offerings.

Take for example the PayPal money-market run on behalf of Ebay, the online auction phenomenon. "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.

2. Mutual Funds

If you've got money in a bond fund - and financial advisors never tire of saying you should - it may well contain more subprime spice than you expected.

Sure, plenty of mortgage-bond meals 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, says Gullapalli. 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.

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 fancy nibbling a bond fund, it might be worth checking the ingredients. Regions Morgan Keegan, meantime, restated the net-asset value of seven funds this Monday, revising them from what might be called last Friday's "guess-timate".

3. Private Pension & Insurance Funds

Investors don't sue if they don't lose any money. Hence the lawsuit now being brought by insurance giant Prudential (US) against State Street, one of the world's largest fund managers.

State Street Global Advisors is charged with failing to mention a change of policy that let it put subprime-based derivatives into two "low risk" funds. Prudential apparently took an $80 million hit in August as a result.

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, and 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 FinancialNews.com.

"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 - it funds educational services! Doesn't it know that minors shouldn't play with subprime derivatives?

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

Moody's Baa Bond Series vs. 10-Year US Treasury Yields

Picture this: 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 somehow managed to bag when you last re-mortgaged and moved home...to 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.

Investment-grade corporate bonds were also paying peanuts 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 when official Fed interest rates sank to their "emergency low" of just 1%, the extra income you'd earn over Treasury bonds was fast vanishing, too.

But rat-a-tat-tat! Help is at hand! That's an investment-bank salesman at the door, carrying a bundle of AAA-rated home-loans set to pay market-beating returns, secured against the non-stop boom in US real estate.

And not a moment too soon.

Who Can Blame the Buyers?

"We got very interested in [equity tranches] 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, for as long as New Mexico's subprime investments don't produce a subprime-sized loss.

But a quick glance at history might have advised against putting public money into subprime and complex mortgage-based bonds:

• 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 the 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 in 2003. But if it did, the case might go a little something like this.

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 has 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.

The world's biggest banks meantime - and as if by pure chance - have just lost well over $20 billion between them on mortgage-backed investments, too. There's more trouble to come judging from Merrill Lynch's statement this week. It's extending its June-Sept. losses by another $2.4 billion, barely three weeks after confessing to a $5.5bn hit.

Merrill's continues, however, to hold almost $21 billion in subprime and collateralized loan obligations. 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 again.

Adrian Ash
BullionVault.com

Head of research at BullionVault.com, the fastest growing gold bullion service online, Adrian Ash is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek magazine.

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