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Peddling Tainted Debt to Florida

Lehman Brothers and JPMorgan sold the state's money market pool securities that defaulted in four months--at the height of the subprime meltdown. Towns pulled out billions, leaving the fund in chaos.

By David Evans Bloomberg Markets February 2008

It was the first day of November and Coleman Stipanovich's world was coming undone. Florida school districts and towns had begun pulling their cash out of the $26 billion money market fund he supervised, after they learned it held subprime-tainted debt. Stipanovich, who earned $180,214 in 2006 as executive director of the State Board of Administration, was in New York in confidential meetings with Lehman Brothers Holdings Inc., the largest U.S. underwriter of mortgage-backed bonds. Lehman was proposing ways to help the state manage the risk of its debt investments, according to a letter the bank sent to Stipanovich after the meeting.

What Stipanovich, 58, hadn't told his boss, Florida Chief Financial Officer Alex Sink, was that Lehman Brothers was the same firm that had sold the state fund $842 million of mortgage-backed debt in July-August 2007. Those securities defaulted within four months and totaled more failing debt than any other bank sold the state, Florida records show. "At the time, I never knew it was Lehman Brothers that actually sold us these investments," Sink says.

Sink was also unaware that former Florida Governor Jeb Bush, who incorporated Jeb Bush & Associates in February 2007, a month after completing his second term, had been hired as a consultant to Lehman Brothers in June. Bush is the brother of President George W. Bush.

In November, school districts and local agencies that kept their cash in the state pool rushed to withdraw $12 billion, or 46 percent, of the money in the fund. On Nov. 29, the state froze the fund to stop all withdrawals. "If we don't do something quickly, we're not going to have an investment pool," Stipanovich told the board that day. Until November, the Florida pool was the largest public money market fund in the U.S. It held cash for about 1,000 school districts, towns and local agencies in Florida.

Stipanovich resigned on Dec. 4. He declined to comment.

Florida CFO Sink is riled up about more than Stipanovich. She says JPMorgan Chase & Co. and Lehman Brothers were offloading tainted debt on Florida and other states at a time when those assets were plummeting in value. The subprime meltdown made front-page news in June when Bear Stearns Cos. disclosed that two of its hedge funds were collapsing because they were stuffed with subprime collateral. During the next two months, Wall Street firms were quietly peddling mortgage-backed securities to the states. And the states, eager for higher returns, were buying them. "Lehman and the other big players in the market decided they didn't like this stuff in their own accounts," Sink says. "Where did they drop it, and who did they dump it to? It looks questionable to me." Joseph Mason, a former U.S. Treasury official and now a finance professor at Drexel University in Philadelphia, says Wall Street had few takers for its subprime-tainted debt. "When they couldn't sell it to more-sophisticated investors, they found less-sophisticated investors like local government investment pools," he says.

At the same time, Lehman Brothers served its shareholders well in 2007, says Bruce Foerster, president of Miami-based corporate financial adviser South Beach Capital Markets. On Dec. 13, the bank reported it had limited a fourth-quarter writedown of $2.2 billion tied to residential mortgages with $2 billion it made on hedges. The board of Lehman, whose shares were down 21.2 percent in 2007 as of Dec. 18, gave Chief Executive Officer Richard Fuld a $35 million stock award for record income in 2007. "What's not to like about a record year?" Foerster says.

Lehman Brothers spokeswoman Kerrie Cohen says the bank had only good intentions in its sales to Florida. "The firm's number one priority is to deliver first-rate products to our clients," she says. "We are disappointed when any security that is purchased by a client underperforms expectations." JPMorgan Chase spokesman Joseph Evangelisti declined to comment for this story.

Florida first revealed that close to $1 billion of its money market fund investments had been downgraded by credit rating companies on Nov. 1, after a month of inquiries by Bloomberg News, as reported in Bloomberg Markets ("The Subprime in the Schoolhouse," January 2008).

States and counties run pools similar to money market funds to hold cash for school districts and local agencies. Most states require fund managers to make only short-term investments in debt such as U.S. Treasuries, certificates of deposit and corporate commercial paper, or short-term loans. Florida and other states have strayed from those guidelines in recent years, buying commercial paper from collateralized debt obligations, or CDOs, and structured investment vehicles, or SIVs. These investments are bundles of securitized loans, often loaded with subprime debt, which is why they offer higher returns than Treasuries. They also hold greater risk of default. Banks and other firms create these "structured finance" packages and put them into a company, usually registered offshore.

Harvey Pitt, chairman of the U.S. Securities and Exchange Commission from 2001 to '03, says state fund managers should have been savvier. "All of this could, and should, have been avoided by careful due diligence, constant reassessment of risk and paying close attention to market trends," he says.

Pool investors like the Jefferson County School District in Florida, which kept more than $4 million of cash in the state fund, were left scrambling to pay their teachers. Hal Wilson, the school board's chief financial officer, stopped checks to vendors to ensure the district's 220 employees would be able to cash their paychecks. "It has been stolen from our local taxpayers because we entrusted their money with the state and our elected officials assured us it was safe," Wilson says.

On Nov. 30, state officials hired New York-based investment management firm BlackRock Inc. to study the fund's holdings and recommend a plan. On Dec. 4, BlackRock reported that about $2 billion of the pool's holdings were in default or had significant credit risk. It recommended that the state put 86 percent of its remaining $14 billion of assets that had no risk of loss or default in what it called Fund A. The remaining 14 percent of distressed assets would go into Fund B and stay frozen indefinitely.

Two days later, the state allowed limited withdrawals from Fund A. Local districts withdrew $1.8 billion from the pool in the first three days after the state lifted the freeze.

Sink, 59, who sits on a three-member board overseeing the fund, says she didn't learn until Nov. 28 that New York-based Lehman Brothers had sold Florida most of its now default-rated commercial paper. Governor Charlie Crist and Attorney General Bill McCollum, who are also on the board, declined to comment. On Dec. 12, Sink asked the audit committee of the State Board of Administration to determine who sold the pool the assets now in Fund B, whether any rules were broken and if managers made adequate disclosure once the fund's holdings had been downgraded.

Sink is upset that when Stipanovich went to New York on Nov. 1 to meet with Lehman Brothers, she had believed that the bank was an independent adviser to the state. "If there's anything that raises my hackles, it's when the executive director said he was relying on Lehman Brothers' advice, when I had suggested that we might need an independent adviser to help us figure out how to deal with these issues," Sink says.

The state's flirtation with the mortgage meltdown began in February 2007 when the fund bought $400 million of one-year Countrywide Bank certificates of deposit from the nation's then largest mortgage lender, Countrywide Financial Corp. The CDs yielded 5.35 percent at the time. BlackRock later quarantined the Countrywide CDs into Fund B because of their "significant" credit risk.

Two years ago, Florida's Local Government Investment Pool held safer debt investments. On Sept. 30, 2005, 25 percent of the pool was invested in U.S. Treasuries and debt issued by U.S. agencies, the safest and most liquid debt sold. The rest was in short-term corporate commercial paper. Interest rates were low, and fund managers for about 100 such pools in the U.S. wanted higher yields. Florida was more aggressive than most states. In October, the Florida pool had the highest return of any public fund in the U.S., earning 5.63 percent. Chasing higher yields not only meant potentially higher returns for taxpayers; it could also mean bonuses for Stipanovich and his colleagues.

The state gave Stipanovich, pool manager Michael Lombardi and compliance officer Lisa Collins financial incentives of up to 8 percent of their annual salaries if they could increase returns for the state's pension fund. Lombardi bought many of the same tainted debt investments that had helped raise the pension fund returns for the state's money market pool, state records show. Pension funds across the U.S. offer managers bonuses.

Stipanovich, 58, who ran the State Board of Administration, which manages $184 billion, was hired in 2000. Two of his three personal references came from then Governor Bush's top aides. "An outstanding individual capable of significant contributions to the board," Sally Bradshaw, Bush's chief of staff, wrote about Stipanovich.

After serving as an infantryman in the U.S. Army during the Vietnam War in 1969 and '70, Stipanovich, who has a master's degree in criminal justice administration from Michigan State University, became a stockbroker and then a branch manager at Paine Webber & Co.'s Tampa office in 1986. In August 1992, he settled a complaint filed against him by Florida's Division of Securities and Investor Protection. The agency found that, as a Paine Webber branch office manager, he failed to supervise a broker who sold unsuitable, money-losing investments to two retired cigar-factory workers: a 73-year-old man, who was living in subsidized housing, and his blind sister-in-law, who was 74. Paine Webber paid $5,000 in investigative costs to the state and $12,624 to the victims.

Stipanovich left Paine Webber five months later to open his own investment company, CoLee Inc. It was dissolved in 2000 after Florida hired him. The following year, he attended a two-day Harvard University seminar called "Dealing With Difficult People and Difficult Situations."

The state promoted Stipanovich to executive director in 2002. In that role, he oversaw management of Florida's pension fund and investment pool. He drew few headlines until 2007. As the subprime crisis unfolded around the world, Stipanovich and Lombardi increased their holdings of high-risk debt. They steadily reduced holdings of government securities in favor of higher-yielding-- and riskier--commercial paper, records show.

In February 2007, London-based HSBC Holdings Plc, Europe's largest bank by market value, reported it had losses of $1.8 billion more than expected on its U.S. subprime lending. In the same month, Lombardi bought the $400 million in Countrywide CDs.

By March, the fund's holdings of government bonds had shriveled to less than 2 percent of its holdings. "As you may have noticed, there are less U.S. Treasury and agency securities than before," Lombardi wrote in a quarterly newsletter to investors. "By focusing on maturities three months and in, we can comfortably accept more credit risk."

In the same month, bad loans soared at New Century Financial Corp., then the second-largest U.S. subprime lender. Its shares plummeted 93 percent that month as it ran out of cash. On March 15, Lombardi had bought another $400 million in Countrywide CDs.

Calabasas, California-based Countrywide shares plunged 75 percent in 2007 through Dec. 12, when shares traded at $10.53. On Aug. 16, Moody's Investors Service had dropped Countrywide's rating three steps to Baa3, one level above junk, from A3.

Lombardi, 50, is a chartered financial analyst with a Master of Business Administration degree from Fordham University in the Bronx, New York. He managed a $250 million short-term fund for the Port Authority of New York and New Jersey from 1988 to '97 in the World Trade Center before going to Florida. He declined to comment.

"Media headlines scream rising delinquencies and falling housing prices," Lombardi wrote in the pool's June newsletter. "The housing market contagion is leaking at the seams."

On June 14, Bear Stearns announced it would liquidate two of its hedge funds, holding more than $4 billion in assets, because their subprime holdings were collapsing. The news roiled global financial markets. Eleven days later, Lombardi took on even more risk for the pool, buying another $150 million of one-year Countrywide CDs, which were then yielding 5.33 percent.

At about the same time, Bush and his new company won a consulting contract from Lehman Brothers, according to Lehman spokesman Randall Whitestone, who declined to say how much Bush is being paid.

On July 2, Lehman Brothers sold Lombardi $250 million of one-month commercial paper, from a structured finance company called KKR Atlantic Funding Trust, yielding 5.37 percent, state records show. KKR Atlantic was rated A-1+ by Standard & Poor's and Prime-1 by Moody's. It matured, and on Aug. 2, Lehman Brothers sold Lombardi $200 million of one-month KKR Atlantic paper yielding 5.53 percent. It was downgraded to default by Fitch Ratings on Oct. 8, and Not Prime, or junk, by Moody's on Oct. 29.

From July 3 to July 9, LehÔman Brothers sold the pool $150 million of commercial paper, from another structured finance company called Ottimo Funding, yielding 5.36-5.38 percent.

Lehman Brothers spokeswoman Cohen says there's no link between Bush and Lehman's sale of debt to Florida. "Bush is a member of the Lehman Brothers private equity advisory board, and his company has been retained by the firm for consulting and advisory services," she says. The former governor declined to comment.

Craig holman, of Washington-based nonprofit public interest group Public Citizen, disputes Lehman Brothers' view. "That defies credibility," says Holman, who lobbies for ethics in government. "It's a clear conflict of interest. Bush is a consultant to the company selling bad investments to the same agency on which he served as a trustee until January."

On July 10, Moody's cut ratings on $5.2 billion of bonds backed by subprime mortgages. Standard & Poor's said that day it might slash ratings on $7 billion of subprime-backed debt.

From July 26 to Aug. 2, Lehman Brothers sold the pool $489 million of one-month KKR Pacific Funding Trust paper, state records show. With each new purchase, KKR Pacific offered a higher interest rate. On July 26, KKR Pacific paid 5.38 percent; on July 27, 5.39 percent; on Aug. 1, 5.46 percent; and on Aug. 2, 5.65 percent.

On July 27, JPMorgan Chase sold the pool $175 million in commercial paper from an SIV called Axon Financial Funding maturing on April 25, 2008, and $31 million of Ottimo, yielding 5.4 percent, state records show. Axon was rated Prime-1 by Moody's, A-1+ by S&P and F1+ by Fitch. The yield was 5.34 percent. Also that month, Lombardi bought $1.8 billion of commercial paper issued by CDOs, including $734 million managed by Bear Stearns.

On Aug. 15, less than three weeks after the pool's purchases, Fitch slashed KKR Atlantic and KKR Pacific to B, or junk, from F1+, citing a decline in value of the underlying residential mortgage-backed securities.

"Unfortunately, the performance of Ottimo, KKR Atlantic and KKR Pacific, which are supported entirely by AAA securities, are reflective of a broader dislocation in the mortgage and asset-backed commercial paper markets," Lehman's Cohen says.

On Aug. 8, Lombardi had bought $100 million of Countrywide six-month CDs with a yield of 5.45 percent. The pool held $830 million of Countrywide debt on Aug. 15, when a Merrill Lynch & Co. analyst raised the possibility of bankruptcy for the company. A day later, Countrywide borrowed the entire $11.5 billion available in its bank credit lines. On the same day, Moody's downgraded Countrywide to one step above junk.

After the downgrade, Countrywide's debt no longer met the pool's minimum credit quality requirements. The pool's operating procedures require a swift meeting of its investment oversight committee when any holding drops below acceptable risk levels.

Countrywide's downgrade, and the decision to continue holding the debt, wasn't communicated to the pool trustees. Sink says it should have been. "Absolutely," she says. "That's why the executive director isn't the executive director anymore."

The committee was composed of Lombardi's boss Robert Smith, senior investment officer for fixed income; Collins, the compliance officer; and Lombardi. On Aug. 22, the committee met and approved a "justification" memo to keep the debt. "Our recommendation is to continue to hold the paper until maturity," the document says. "Naturally, we will continue to monitor the credit markets to take advantage of any sale opportunities."

State records show the pool owned $234 million of paper issued by Buckingham CDO III on that date, holding 40 percent subprime collateral. "I think we were asking a lot of the right questions," Sink says. "We just weren't getting the right answers back."

From August to October, the committee decided to hold five debt holdings that had been downgraded or had defaulted. In late October, the board's investment oversight committee allowed the pool to keep a total of $532 million in downgraded commercial paper from KKR Atlantic and KKR Pacific. The debt of both had been lowered to D for default by Fitch, after they had been downgraded to B, or junk, from F1+ two months earlier. Ottimo was downgraded to junk by S&P on Oct. 3 and cut to default on Nov. 9. Axon was slashed to default by S&P on Nov. 27.

The committee meetings to hold the spiraling debt had no agendas, took no votes and kept no records of the sessions, says Linda Lettera, general counsel of the state board. It went through the same process each time one of the pool's holdings was downgraded below its minimum standards. "That's just not the way you do business," Sink says. "The way business is conducted over there is going to be very different going forward."

On Sept. 12, Lombardi wrote a memo to compliance officer Collins, saying, "All asset-backed commercial paper has been tainted with the subprime mortgage troubles."

Stipanovich, in an update to the pool's trustees on Oct. 15, said the pool has no direct exposure to subprime mortgages and buys only asset-backed commercial paper from 150-200 approved programs. He described negotiations with KKR Atlantic, KKR Pacific and Ottimo Funding to extend the time of commercial paper that couldn't be repaid.

On Nov. 1, the pool's third-quarter newsletter revealed the first sign of potential losses to the pool's participants. It said that 3.4 percent of its holdings, including Axon, Ottimo, KKR Atlantic and KKR Pacific, were downgraded below the pool's acceptable risk levels. It also disclosed ownership of $440 million of Harrier Finance Funding, a second SIV. "No one can consistently predict the future course of the financial markets and residential mortgage default rates, but credit markets are showing some signs of gradually recovering," the newsletter said. It omitted mention of the $650 million of the downgraded Countrywide CDs.

Banks had written down more than $20 billion in subprime holdings by Nov. 1. In October, Merrill Lynch had reported a loss of $2.24 billion, the largest in its 93-year history. On Oct. 30, Merrill ousted Stan O'Neal as its chief executive officer.

The day after O'Neal was fired, Stipanovich was in New York, meeting confidentially with Lehman Brothers. In a presentation at the Nov. 1 meeting, Lehman Brothers included a graphic titled "Potential Opportunities to Explore." It suggested that Florida could buy more structured finance commercial paper from Lehman Brothers for the state pension fund. "Florida is very well funded relative to its peer group," the graphic said.

Back in Florida four days later, the State Board of Administration determined that 7.2 percent or $3.6 billion of its then $50 billion of short-term investments, which includes the investment pool, were on credit watch for possible downgrades. In the first two weeks of November, local districts had withdrawn $2 billion from the pool, records show.

On Nov. 12, Lehman executive Marty Klein sent Stipanovich an e-mail. "On behalf of my colleagues at Lehman Brothers, I would like to thank you for your time at our recent lunch," Klein wrote. "We'd like very much to continue to build our relationship with the Florida State Board of Administration. Given our broad capabilities, we think we can be helpful on several fronts."

On Nov. 14, the state board held a public meeting to discuss all of its investments, including the pool for local districts and the pension fund. "The SBA's bond and money market investments have maintained high overall credit ratings," Stipanovich said. "The only disappointment that we've been dealing with is the credit downgrades." He said the downgrades included 4.7 percent or $2.28 billion of the board's total $50 billion of short-term debt holdings.

"Most importantly, I want to emphasize that no client has ever lost money in the SBA's short-term fixed-income investment program, and we remain confident that our portfolios in this program will meet their objectives," Stipanovich said. "I feel very good about our situation."

Governor Crist offered reassuring words for Stipanovich. "It's always easier to be a Monday morning quarterback," he said. "We all know that. But I just want to thank you for your diligence and for your staff's work. We have confidence in you. Sometimes these things do get blown out and sensationalized."

In the next two weeks, the credit downgrades and defaults of pool debt holdings overtook the positive spin Stipanovich had given the governor and the pool's trustees. Local agencies withdrew $10 billion more from the pool, until the state froze the fund on Nov. 29. That's when Stipanovich officially turned in his resignation. State officials selected BlackRock to manage the pool the next day.

For those running the Florida pool, the best hope is that the audit committee can sort out what went wrong and restore the fund's credibility and financial stability. If the committee doesn't, the state might have no choice other than shutting the pool down.

David Evans is a senior writer at Bloomberg News in Los Angeles.


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