The Subprime in the Schoolhouse

The mortgage contagion has hit state-run investment pools that handle $200 billion in funds for schools and cities. Taxpayers are in the dark.

By David Evans Bloomberg Markets January 2008

Hal Wilson smiles at the blue numbers on his desktop screen. His money is yielding 5.77 percent. For the chief financial officer of Florida's Jefferson County school board, that means the $2.7 million of taxpayer funds he's placed in the state's Local Government Investment Pool is earning more on this October day than it would get in a money market fund. And Wilson says he knows the Florida officials who manage the funds of the 1,559-student district have invested them wisely.

"We're such a small school district," Wilson, 55, says. "We don't have the time or staff for professional money management. They have lots of investment advisers. It's risk free and easy."

It may be easy, but it's not risk free. What Wilson didn't know in October--and what thousands of municipal finance managers like him across the country still haven't been told--is that state-run pools have parked taxpayers' money in some of the most confusing, opaque and illiquid debt investments ever devised. These include so-called structured investment vehicles, or SIVs, which are among the subprime mortgage debt-filled contrivances that have blown up at the biggest banks in the world. Red ink from subprime debt rocked Merrill Lynch & Co., the world's biggest brokerage, in October, spurring a $2.24 billion third-quarter loss, an $8.4 billion writedown and the ouster of Chief Executive Officer Stan O'Neal. Less than a week later, subprime losses felled Charles Prince, CEO of Citigroup Inc., the largest bank in the U.S.

SIVs are typically offshore companies created by banks and other firms to sell short-term debt to buy mortgage securities and finance company bonds with higher yields. They profit on the spread between the two. Banks such as New York-based Citigroup, which manages $83 billion in SIVs, collect fees for running SIVs while keeping their contents off the bank's books. SIVs finance themselves by selling asset-backed commercial paper, or short-term loans backed by collateral such as mortgages. When the subprime debt market blew up in August, investors stopped buying SIV commercial paper. As a result, in September and October, SIVs didn't have the cash to pay debt holders of more than $8 billion of their paper.

The banks had also peddled SIV paper to their clients, including state officials who oversee pools of taxpayer funds like Florida's. The $27 billion Florida pool, the largest in the U.S., has invested $2 billion in SIVs and other subprime-tainted debt, state records show. About $725 million of these holdings have already defaulted.

On Nov. 14, following a month of inquiries by Bloomberg News to Florida officials, Florida Governor Charles Crist held a public meeting disclosing that 4% of Florida's short-term investments had been downgraded. State pool losses may hit taxpayers in places such as Jefferson County in the form of reduced services or higher taxes.

Jefferson County's Wilson says he still trusts the Florida pool managers and will keep the schools' money in the fund. "I really hope this isn't any worse than we know today," he said after the Nov. 14 meeting. "If something happened to that investment, our county would be devastated."

State officials have no business putting taxpayer money into debt investments that have baffled even the most-seasoned Wall Street executives, says Joseph Mason, a finance professor at Drexel University in Philadelphia and a former economist at the U.S. Treasury Department. "Municipalities shouldn't be playing like they're expert investors, squeezing the last penny out of SIVs," Mason says. "They're making a giant jump into a new product area which has unknown, unforeseen risks."

Thousands of school, fire, water and other local districts across the U.S. keep their cash in state- and county-run pools. These public accounts, modeled after private money market funds, are supposed to invest in safe, liquid, short-term debt such as U.S. Treasuries and certificates of deposit. All told, there were about 100 such pools, containing more than $200 billion at the end of 2006, according to Westborough, Massachusetts-based iMoneyNet, a research firm that tracks these funds.

Public fund managers say they've bought SIV debt because it had the safest credit ratings and offered higher yields than other short-term fixed-income investments.

SIVs, many of which are assembled by London-based bankers, had a low profile until some of them collapsed. The $7 billion Cheyne Finance SIV, incorporated in Delaware, defaulted on Oct. 17.

Two days before that, Treasury Secretary Henry Paulson, former CEO of Goldman Sachs Group Inc., stunned investors by saying banks had agreed to start a private fund of about $80 billion to help bail out the $320 billion in SIVs that may run short of cash to pay investors. Without such protection, SIVs may be forced to auction their debt at substantial discounts, leading to immediate recognition of tens of billions in losses. When Paulson proposed the fund, few people had heard of SIVs. Even fewer knew that states were buying their commercial paper. (For more on Paulson, see "Paulson's Peril," also in this issue.)

Among the places caught up in the SIV and subprime snarls are Connecticut, Florida, Maine, Montana and King County, Washington. Public funds hold $1 billion of defaulted asset-backed commercial paper, including $273.5 million from SIVs. Montana entrusted $465 million, or 19 percent of its $2.5 billion investment pool, to SIVs.

Nobody knows how much more pain is coming. State funds could lose hundreds of millions of dollars, says Lynn Turner, chief accountant of the U.S. Securities and Exchange Commission from 1998 to 2001. "If you're dealing with short-term money market funds, people expect those to have low risk and not be invested in these SIVs and other very high-risk instruments," Turner says.

If public funds lose money, towns and local agencies could raise taxes, sell more debt or, more likely, trim budgets, Turner says. "Cutting spending usually means people losing jobs because someone else didn't do their job," he says.

The banks that specialize in structured finance, which includes SIVs and collateralized debt obligations, work closely with rating companies. CDOs are packages of asset-backed securities that bundle debt securitizations, including subprime mortgages, bonds and other loans. One type of SIV called an SIV-lite is structured like a CDO, holding collateral of residential mortgages and home equity loans. Banks and finance firms pay fees to Standard & Poor's, Moody's Investors Service and Fitch Ratings to help them create structured finance debt and give it credit ratings. Moody's reported in March that 42 percent of CDOs sold in the U.S. in 2006 contained subprime securities. (For more on the role of credit rating companies in creating CDOs, see "The Ratings Charade," July 2007.)

Municipal money managers face a dilemma because the credit raters have proved unreliable in grading SIVs and CDOs. "You have tainted meat on the inspection line," says Sean Egan, managing director of Egan-Jones Ratings Co., a Haverford, Pennsylvania-based firm that's paid by investors, not issuers, to rate debt. "You have rating firms acting as meat inspectors, and unfortunately the rating firms are being paid by the meat producers. It underscores the severely flawed structure of the industry."

One pool stung by SIVs that had been awarded top marks by rating companies is the Seattle-based King County Investment Pool. The fund, which manages cash for about 100 agencies in the county, invested $153.5 million in commercial paper issued by three SIVs, each of which enjoyed the top grades from S&P and Moody's until weeks before they defaulted.

King County finance director Ken Guy says he thought the fund was making a safe investment when it bought $53.5 million in commercial paper of an SIV-lite called Mainsail II in July. Fund managers found that Mainsail, incorporated in the Cayman Islands, was top rated, Guy says. The pool bought the paper from New York- based Merrill Lynch. Just three weeks after King County invested, Moody's dropped its rating for Mainsail by three notches from its highest Prime-1 rating to its lowest rating, Not Prime, or junk. Mainsail failed to make payments to investors, including King County, on Oct. 4. "We've never seen anything that was that severely downgraded that quickly," Guy says. "It was very frustrating for us to see the ratings come down so rapidly for something that was so highly rated." Moody's spokesman Anthony Mirenda says, "Ratings are not static. We closely monitor performance and market trends."

Merrill Lynch also sold Mainsail paper to Maine. The State Treasurer's Cash Pool bought $20 million in Mainsail paper on Aug. 8. That represents about 3 percent of the $726 million fund, according to Deputy Treasurer Barbara Raths. She says her state trusted the SIV-lite because it was top rated and Merrill Lynch broker Mary Lou Ruch recommended it. "She said, 'This meets your criteria,'" Raths says. Mainsail didn't pay when it was expected to on Aug. 31. Merrill Lynch spokesman Bill Halldin, Ruch and Geoff Smailes, founding partner of London-based Solent Capital Partners LLP, which ran Mainsail, declined to comment.

The subprime debacle that eventually spurred at least $40 billion in Wall Street writedowns and cost Merrill Lynch's O'Neal and Citigroup's Prince their jobs intensified in February 2007. London-based HSBC Holdings Plc, Europe's largest bank by market value, reported that month it had losses of $1.8 billion more than expected on its U.S. subprime lending. Bad loans also soared at New Century Financial Corp., then the second-largest U.S. subprime lender. Its shares plummeted 93 percent in March as it ran out of cash. The crisis spread to Wall Street in June, when two Bear Stearns Cos. hedge funds holding subprime mortgage debt posted losses of $1.5 billion. Bear Stearns fired Warren Spector, the firm's co-president for fixed income and asset management. In the next two months, New York-based Bear Stearns stock lost 30 percent of its value.

"There are not many people who avoided this," said Coleman Stipanovich, Florida's executive director of the state board of administration, at the Nov. 14 meeting. "I think we need to pay closer attention to our exposures."

State fund managers looking for more information on SIVs won't find it in SEC filings; there are none. SIVs, which are companies with no employees, aren't required to publicly disclose audited financial statements.

"You don't actually know much about the collateral pool until after you've made the investment," says Darrell Duffie, a professor of finance at the Stanford Graduate School of Business in California. Duffie, a paid consultant to Moody's, says even credit rating companies have a tough time analyzing SIVs and CDOs. "These are really hard products to deal with," Duffie says.

One man who buys CDOs and SIVs is Michael Lombardi, the $97,609-a- year civil servant who manages Florida's $27 billion investment pool in Tallahassee. The pool has existed since 1982, and its Web site says its objective is to "provide a short-term, very liquid, high-quality investment" for local governments to hold their cash while earning the best possible returns. Lombardi purchased $1.8 billion of CDO paper in July, including $734 million managed by Bear Stearns. It has since matured. Another $615 million of SIV paper remains in the pool. In August, Lombardi, 50, who has managed the pool for four years, was investing public money in asset-backed commercial paper yielding as much as 6.7 percent, even as the subprime collapse was in full swing. He declined to comment.

As of Oct. 31, the Florida fund owned at least $1.5 billion of assets that, because of downgrades, failed to meet the state's requirement that its debt holdings have top credit ratings, according to state records obtained under open records laws. That was 5 percent of the pool. At the Nov. 14 public meeting, no state official said any holdings had defaulted.

The board decided to keep $900 million in asset-backed commercial paper slashed to junk between August and October, state records show. Two of the three board members, Governor Crist and Attorney General Bill McCollum, declined to comment. "It bears looking into," says Chief Financial Officer Alex Sink, the third member of the board.

On. Aug. 21, Sink's office asked Stipanovich if the pool's CDOs faced subprime risk. "None of these CDOs are backed by subprime mortgage loans," Stipanovich wrote in an e-mail reply the next day. State records show the pool owned $234 million of paper issued by Buckingham CDO III on that date, holding 40 percent subprime collateral. Stipanovich declined to comment.

On Sept. 12, Lombardi sent an e-mail to Manager of Operations Lisa Collins, saying he couldn't accurately price $725 million in face value debt then held by the pool in downgraded commercial paper. "The Wall Street dealer community is reluctant to quote a price on anything that doesn't trade in the secondary market," he wrote. He estimated in the memo that those holdings were worth 96-98 cents on the dollar.

As recently as Oct. 24, the board's investment oversight committee allowed the pool to keep a total of $532 million in downgraded commercial paper from KKR Atlantic Funding Trust and KKR Pacific Funding Trust. The debt of both had been lowered to D for default by Fitch Ratings, after they had been downgraded to B, or junk, from F1+ two months earlier. That debt was assembled by San Francisco-based KKR Financial Holdings LLC, a publicly traded credit fund partially owned by buyout firm KKR & Co. LP.

The committee also approved keeping $180.7 million in paper from Ottimo Funding, registered in the Cayman Islands, which on Oct. 3 had been cut to junk by S&P from A-2, its third-highest rating. On Oct. 17, Moody's cut Ottimo to Not Prime from Prime-1. S&P slashed it to default on Nov. 9. New York-based Lehman Brothers Holdings Inc. sold Florida all of its KKR Atlantic and KKR Pacific commercial paper and most of its Ottimo paper. Lehman spokesman Randall Whitestone and KKR spokeswoman Molly Morse declined to comment.

Tallahassee-based Florida League of Cities Inc., which represents the state's 412 municipalities, has $7.2 million invested in the Florida pool. Jeannie Garner, the league's director of financial services, says local agencies are under the erroneous impression that the pool will be rescued by the state in case of disaster. "A lot of people mistakenly believe it's backed by the state, and it's not," she says.

Every day, Florida officials post on the pool's Web site its daily and monthly yields, which are among the highest in the nation for local government investment pools, according to Tracs Financial LLC, a Park City, Utah-based research firm. As of Oct. 31, Florida hadn't disclosed its defaults or junk-rated debt.

"It's a case of see no evil, hear no evil, speak no evil," former SEC accountant Turner says. He adds that local school districts and other pool participants should be fully informed of defaults in debt held by the fund. "I think any investor would want to know if their money market fund was experiencing defaults," he says.

Florida's pool bought $175 million of short-term debt issued by Axon Financial Funding, an SIV, from JPMorgan Chase & Co. on July 27. Axon was downgraded to Not Prime from Prime by Moody's on Oct. 23. S&P cut it to C, one level above default, from A-2, on Nov. 9. TPG-Axon Capital Management LP managing partner Dinakar Singh and JPMorgan spokesman Brian Marchiony declined to comment.

Buying SIV debt and asset-backed commercial paper isn't the only way in which the Florida pool has been scorched by the subprime crisis. The pool also bought $650 million in certificates of deposit from Countrywide Bank FSB, a unit of Countrywide Financial Corp., the largest home mortgage lender in the U.S. The CDs mature from February to June. The bank's rating was downgraded to Baa1, three levels above junk, from A2, by Moody's on Aug. 16. That change knocked the CDs below the pool's minimum credit grade requirements. Still, the oversight committee decided on Aug. 22 to keep the Countrywide investment, state records show.

Shares of Calabasas, California-based Countrywide Financial fell 67 percent in 2007 as of Nov. 9, when the stock traded at $13.83. Credit raters have repeatedly cut the lender's debt rating amid the worst housing slump in more than 16 years.

On Nov. 1, in its quarterly newsletter, the Florida pool revealed for the first time that holdings representing 3.4 percent of its assets had been downgraded below the quality it's allowed to purchase. It omitted the Countrywide downgrade.

Florida CFO Sink, treasurer of the board of trustees that oversees the state pool, says she wasn't briefed about the $900 million of downgrades before the Nov. 1 newsletter. "I wasn't aware of that," she says. "Just because it's been downgraded to junk doesn't mean that it's not good money."

Palm Beach County Comptroller Sharon Bock won't take that risk. Bock sent an e-mail to an official of the pool's board on Sept. 5 seeking assurance that its holdings weren't jeopardized by the subprime meltdown. She says Mike McCauley, a senior officer of the board, assured her office the investments were all top rated. After discovering the downgrades, she says the county chose to find a safer place to stash $400 million in expected tax receipts. "We're concerned there was not full disclosure," she says. "The concerns are high enough that we decided that no more of our money is going into the pool until they are able to adequately show their risk is minimized." McCauley declined to comment.

Local Florida agencies and districts might have had a better idea of the pool's safety if the fund had sought a credit rating. About half of the local government pools in the U.S. have ratings, according to Moody's and S&P. The King County Investment Pool in Seattle is one of them. Finance director Guy says the $4.1 billion fund's managers decided in 2005 to hire S&P to grade the pool. He wanted to reassure investors of its safety. S&P gave the fund its highest AAA rating.

The King County fund draws 40 percent of its cash from the county and the rest from about 100 school, fire, utility and other districts. In August, the fund had 25 percent of its money in commercial paper. At the end of August, after Moody's downgraded Mainsail II, the Metropolitan King County Council voted to buy the pool's $53.5 million SIV debt, taking it out of the pool, in order to protect the local agencies that had invested in it. The Council did so on the condition that the county would return the SIV paper to the pool should any other investment be downgraded to junk. Finance director Guy says he and the county had believed Mainsail was the only holding that would be downgraded. "When we set aside Mainsail, we thought it was an aberration," he says.

Less than two weeks later, on Sept. 12, the pool's $100 million investment in another SIV, Rhinebridge, incorporated in Ireland, was placed on negative watch by S&P. On Oct. 19, S&P downgraded it to default.

In September, King County hired PFM Asset Management LLC to analyze its predicament. Philadelphia-based PFM, which manages more than $26 billion of public money, had disposed of the $2 billion of asset-backed commercial paper it managed for local pools in early July because it was concerned about an imminent subprime meltdown, says Michael Varano, senior managing director at PFM. "It was very hard to understand the collateral in what they were buying," Varano says of the King County SIV debt.

While awaiting the PFM report, Guy learned on Oct. 4 that the fund's $50 million investment in commercial paper of the Cheyne Finance SIV was downgraded by Moody's to Not Prime from the top rating of Prime-1. The SIV's asset value had been dropping for months, forcing it to liquidate holdings to make its payments. On Oct. 10, PFM produced a 30-page report on the pool, saying King County had slipped into a common trap of buying SIV debt that appeared to be safe because it had top credit ratings. "The broker-dealer community fostered the impression of safety," says Robert Cheddar, PFM's chief credit officer and co-author of the analysis. "Unlike a stock or other actively traded security, there is little daily information to make judgments on."

The next day, Guy says he breathed a sigh of relief when $50 million of Rhinebridge debt due on Oct. 11 was paid off on time. That calm ended in less than a week. On Oct. 17, Guy learned the pool's $50 million investment in Cheyne Finance had defaulted. A day later, the pool's other $50 million of Rhinebridge wasn't paid when it came due.

Then, on Oct. 19, S&P downgraded Rhinebridge to D for default, from A-1. That forced the county, under its agreement with the fund, to send Mainsail back into the pool because more than one of its assets had its credit rating lowered. As a result, the pool owned $153 million of defaulted debt.

"This showed that Mainsail's problem wasn't an aberration," Guy says. "This is more of a systemic problem with asset-backed commercial paper." He says the pool has stopped all such purchases.

Connecticut learned the same lesson when its $5.2 billion short- term investment pool put $100 million, or 2 percent of its fund, in Cheyne Finance debt, according to Assistant Treasurer Lawrence Wilson. Before the Cheyne Finance default, the Connecticut pool produced the highest yield in the U.S. in July, 5.43 percent, according to Tracs Financial data, with about 10 percent of its assets invested in CDOcommercial paper backed by subprime mortgages.

Montana's $2.5 billion Short Term Investment Pool dodged the Cheyne Finance bullet. Its $30million holding matured on Sept. 25 and was paid off, two weeks before it was downgraded to Not Prime by Moody's. The state pool isn't in the clear with SIVs. It still owned $465 of SIV paper on Sept. 30. That included $90 million of Axon Financial Funding debt maturing April 15. Axon, representing 3.6 percent of the pool's assets, was cut by S&P to C, one level above default, on Nov. 9. Cheyne Finance and Axon had top credit ratings when the Montana pool bought the SIVs. "There wasn't anything that suggested they would have an extraordinary problem," says Cliff Sheets, Montana's chief investment officer.

He says the pool has become more conservative after managers learned not to place too much trust in credit ratings. "Once burned, twice shy," he says. "We're not the only participant in this market that's had amind-set change as far as credit rating agencies go."

Now, local investment pool managers like Sheets, once lured by the big returns from hard-to-comprehend SIVs, are going back to the basics of investing: Do your own research. Remember that higher returns bring more risks and top credit ratings can be misleading.

State-run investment pools should work together to fund independent analysis, says John Coffee, a securities law professor at Columbia Law School in New York who testified before the U.S. Congress in September 2007 about debt ratings. "If you can't understand it and it's not transparent, then you shouldn't buy it," Coffee says. "The typical public investor simply doesn't have in-house capacity to do its own securities analysis. Structured finance is inherently opaque."

Until municipal fund managers learn to steer clear of traps like CDOs and SIVs, taxpayers' money will be at risk--and it's not likely anyone will tell them.

David Evans is a senior writer at Bloomberg News in Los Angeles. davidevans@bloomberg.net With reporting by Martin Z. Braun in New York.

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