Subprime Time

The market is always out to get you, and even AAA-rated investments are vulnerable.

And so it was, on a cool December day in Tallahassee, financial managers from local governments all over Florida were in Tallahassee to figure out how to work through the crisis that struck the state-run Local Government Investment Pool when a handful of AAA-rated investments suddenly turned doubtful.

Barbara Novick, vice chairman of global investment manager Blackrock, the firm brought in to take over management of the troubled investment pool, looked around at the crowd. “Cash is supposed to be boring,” she said with a grin.

How did this happen? How did investments carrying the highest rating for safety bring Florida’s local-government pool to the brink of collapse in November and put its top executive out of a job?

These were not, after all, the infamous “subprime loans” to unqualified borrowers. These investments were AAA rated by Moody’s, Standard & Poor’s and Fitch. And the local-government pool was run by a Florida agency with a national reputation for its well-managed pension fund, the 12th-largest government-managed fund in the world. This was supposed to be little more than a money-market fund, a place for local governments to park cash until they needed it.

And it was, until the investment world started to panic over rising defaults in residential mortgages about a year ago. After that, the panic spread to just about every kind of debt. By the end of October, the panic spread to Florida’s local governments, who created a “run” on the investment pool to get their money out while they still could [Feb. 2008: Florida’s 'Run on the Bank'].

From AAA to junk
The simple answer is that the AAA rating assigned to those investments proved to be a ghastly miscalculation by the rating agencies. Coleman Stipanovich, three weeks before his resignation as executive director of Florida’s money manager, the State Board of Administration, acknowledged “an over-reliance on the credit rating agencies” in making the fateful investments in the now-controversial assets.

James Grant, the widely revered editor of the Grant’s Interest Rate Observer newsletter, is more blunt. He has referred to “the cyclical dunce caps that now crown the heads of Moody’s, S&P and others.”

Florida’s local-government pool, like most other investors in short-term instruments, had long relied on commercial paper, the very short-term notes of highly rated corporate borrowers. A variation on that was asset-backed commercial paper — notes from somewhat less worthy borrowers that boosted the investment rating by posting assets as collateral. These were abbreviated as “ABCPs,” or, more generically, asset-backed securities (ABSs).

It seemed only a small leap, then, for Wall Street to turn long-term mortgages into a special kind of asset-backed instrument.

There was an active market in these mortgage-backed securities, which went by names like “structured investment vehicles (SIVs)” and “collateralized debt obligations (CDOs).” These instruments create short-term debt out of long-term mortgage obligations and profit from the spread between long- and short-term interest rates. The bundler creates what is basically a short-term bond, with the bundle of long-term mortgages as collateral, then further divides the securities into “tranches,” some high quality, some not. Those tranches are sold to investors based on their risk tolerance. And by borrowing money at short-term rates to finance these instruments, the packagers turbocharge the returns even further.


Related: Another Local Government Investment Fund Collapses

Here’s how it worked:
Mortgage lenders — both the subprime variety, like New Century Financial, or more traditional mortgage lenders - would park their new mortgages with the investment banks, like Bank of America and Merrill Lynch, which would bundle them into SIVs and CDOs and other securities. Since that process took a few weeks, the big banks would provide a sort of bridge loan back to the subprime lenders, which would use that cash to turn around and make more subprime loans. Sometimes the transaction included a little-noticed and unused provision that allowed the big banks to force the lenders to repurchase the loans. That provision would prove catastrophic one day, but for the time being all was well.

The financial firms went to the credit agencies and wanted to get the same kind of investment-grade ratings that had been applied to regular commercial paper. The high ratings made these SIVs and CDOs eligible for purchase by low-risk investors like Florida’s local-government pool. Moody’s, S&P and Fitch all collect a fee from the very firm that is seeking the rating.

Moody’s, S&P and Fitch looked at the bundles of geographically diversified loans, saw low default rates on such loans in recent years and assigned investment-grade ratings. Unfortunately, the rating agencies were evaluating assets in the context of a pretty strong economy and booming housing market, not in the context of some unexpected event or economic recession. But booms end.

“Investors on the whole are a trusting lot,” newsletter editor Grant told the Charter Financial Analyst Institute last October. “We believe in new eras. ... We believe in the ability of ratings agencies to plumb the complexity of ABSs and CDOs and surmount somehow the temptations their business models put in front of them.”

The subprime crisis began as the housing market started turning downward in late 2006, interest rates rose and defaults increased. The banks got queasy about rolling over these bridge loans and even started enforcing some repurchase agreements.

As defaults on the collateral grew, the creators of these fancy instruments could no longer meet their obligations on interest or repay the principal when due.

The rating agencies suddenly were turning their AAA ratings into junk.

Florida joins in, too
A couple of years ago, investment professionals spoke of a “world awash in liquidity.” Interest rates were falling, and money was looking for higher returns. These SIVs and CDOs seemed just the thing to institutional investors.

One of those institutional investors was Florida’s State Board of Administration, which ran not only the world’s 12th-largest pension fund for Florida government employees but also a $27-billion pool on behalf of Florida’s local governments to help them manage their idle cash. This pool, created in January 1982, was called the Local Government Investment Pool, or LGIP.

That pool, which offered its local-government investors ready access to their cash just as money-market funds do, can invest only in short-term investments.

The SIVs and similar securities were enticing investment opportunities for people with cash and a short time horizon. The high-yielding mortgages turbocharged the portfolios of mostly AAA-rated short-term corporate debt and commercial paper. The SBA’s local-government investors loved getting interest rates of as much as 5.77% on their idle cash, much more than they could get in the money-market funds offered by their banks.

This income boosted local government budgets without more taxes.

The investment pool with its superior returns was an especially attractive deal for small local governments, which could never afford the management expertise to make such investments and could not diversify their holdings very much on their own. The AAA ratings and the active market in these mortgaged-backed securities meant that, even though maturities were 60 days or more, they could easily be sold if the SBA faced unexpected withdrawals from its investment pool.

When the housing market started going stale and loan defaults started making news early in 2007, the SBA wasn’t concerned. It had taken the most highly rated tranches of those CDOs and SIVs. Prices were falling in the AAA-rated securities as well, but it was just because the banks themselves had stopped investing to raise cash to deal with the subprime problems.

The market may have been troubled, but the SBA was not. Managers thought they were Warren Buffett, a guy with great instincts grounded in experience and knowledge who sees panic and thinks opportunity. They were still buying these investments through the first half of 2007. But they were making one big investment mistake: They were trying to catch a falling knife. Bad idea. Let an investment finish falling and then buy. When there’s no one left to panic, that’s when the truly shrewd investor pounces.

The trade unwinds
At the end of July, the SBA held securities from 28 CDOs and SIVs, its newsletter reported in November. On Aug. 22, the SBA reviewed all its CDO holdings but was looking only at “subprime” exposure. It counted $1.5 billion worth in all its funds (mostly the pension fund), all with “the highest short-term credit ratings from Moody's, S&P etc.” and all “very short-term in nature,” the SBA reported to its trustees on Nov. 9.
There was no “subprime” collateral in other types of holdings, either.

Suddenly — or so it seemed, though the warnings were visible in hindsight — the market for all these debt securities just disappeared in July. The only large financial institution untainted was Goldman Sachs, which had brilliantly gotten out of the market (to the regret of those smaller subprime lenders) the previous fall. Citicorp and Merrill Lynch fired their chief executives, took huge loss write-downs and moved the distressed securities out of their sales inventories and onto their balance sheets.

In Florida, word was getting around, with the help of private investment advisers who coveted some of the fees local governments were paying to the SBA. The whispers went: Do you know about the investment pool’s exposure to the subprime crisis?

But you have to give the SBA credit: It never panicked — not, at least, until its investors did and its trustees too. On Nov. 29, Executive Director Coleman Stipanovich was gamely offering up some kind of undefined buyout, much like those that the big banks had done, because he still believed — the SBA believes even today — the investments would eventually close out at 100 cents on the dollar.

But standing in front of a room saying, “There is no cause for alarm” is not an effective antidote to the “shoot first, ask questions later” zeitgeist that pervaded the credit markets in the last quarter of 2007.

The SBA’s explanations of the situation were almost impenetrable. First of all, it didn’t even have the e-mail addresses of all its investors. An SBA insider says an emergency communication plan was worked on after the pension fund lost $300 million on Enron in 2001, but Stipanovich dismissed the plan as unnecessary.

The SBA’s key response to growing investor concerns was its quarterly newsletter to investors and a simultaneous report to its trustees dated Nov. 9. The report opened with multiple pages about its terrific holdings, diversification and investment record. A reference to problems in the credit markets first appeared on page 11.

“The only disappointment,” the newsletter noted about its holdings, “has been with isolated credit downgrades accounting for 3.4% of the par [face] value.”

Huh? What was that?

“Moreover,” the newsletter went on, “we have participated in restructuring negotiations with two asset-backed commercial paper issuers to make certain that collateral is held in trust to pay principal and interest.”

Restructuring?

“The Pool owned extendable ABCP (asset-backed commercial paper) issued by seven programs that recently chose to extend maturities,” the SBA said. Not to worry, though. “All seven were collateralized by Prime and Alt-A mortgages; the latter mortgages have high FICO (credit) scores and low loan to value ratios, but non-standard documentation.” Two of these, from RAMS Home Loans in Australia, exercised a right to “extend” their maturities at higher interest rates. (RAMS was later acquired at the verge of bankruptcy.) Two investments from KKR, famous in the 1980s as the “Barbarians at the Gate” of RJR Nabisco, went into restructuring discussions that included eventually putting the collateral in the hands of the investors.

Another holding, Axon, was downgraded from AAA to junk.

The problem isn’t really in the investments, the SBA was trying to argue, but in the market. As the SBA put it in November, “investor anxiety about the sub-prime issue spilled over into the commercial paper market.” Yields spiked, and when yields spike, the value of the underlying asset goes down to bring the interest rate in line with the market.

Although its own AAA-rated securities had credit-worthy borrowers with credit scores and low delinquencies, “the sudden and wholesale lack of investor demand caused some prices to plummet by 5% to 10%” instead of the usual range of barely half a percentage point.”

In fact, it got to the point that nobody’s was buying, period.

So when the pool’s investors started pulling their money out, the SBA would have suffered losses of perhaps 10% if it cashed out of those holdings before maturity — it could find a buyer at all. Stipanovich wanted to simply sell the assets to the state’s huge pension fund, with its long-term horizon.

The state’s top elected officials would have none of that. The only other choice, it seemed, was to close the fund and figure out what to do next.

Tags: Politics & Law, Government/Politics & Law