No matter where they came from, what language they spoke, or whose money they were looking after, they all had one thing in common: they had lined up to buy products they didn't understand, offering returns that made no sense, from middlemen who couldn't care less about what they were selling.
Today, they form part of a fast-growing group revealing billion-dollar losses by the day.
In "Florida School Fund Rocked by $8 Billion Pullout," Bloomberg reports on a state-run bagholder -- er, investment pool -- that is suffering the consequences of ignorance and greed.
Florida local governments and school districts pulled $8 billion out of a state-run investment pool, or 30 percent of its assets, after learning that the money- market fund contained more than $700 million of defaulted debt.
Orange County, home of Disney World, removed its entire $370 million from the pool on Nov. 16, two days after the head of the agency that manages the state's short-term investments disclosed the defaulted debt in a report delivered to Governor Charlie Crist.
"Our primary goal is to protect our funds," said Jim Moye, Orange County's chief deputy comptroller, from his office in Orlando. The county's school board withdrew $388 million this week, following other local governments that pulled funds, including Miami-Dade County and Pompano Beach. The withdrawals, made since Nov. 14, were disclosed to Bloomberg News in a response to an open-records request.
The State Board of Administration manages about $42 billion of short-term investments, including the pool, as well as the state's $137 billion pension fund. Almost 6 percent, or $2.4 billion, of its short-term investments consist of asset-backed commercial paper that has defaulted. Those holdings include $425 million in Axon Financial, a structured investment vehicle, or SIV, according to state records.
Proposed Credit Protection
The agency, in a statement released this evening, said its board of trustees will meet on Dec. 4 to consider acquiring credit protection for about $1.5 billion of pool investments from four issuers: Axon Financial, KKR Atlantic Funding Trust, KKR Pacific Funding Trust, Ottimo Funding and Countrywide Bank FSB.
"Certain pool investments have been downgraded below purchase credit rating guidelines, but they have continued to pay principal and interest," the statement said. "The pool has collected approximately $64 million in principal and interest payments since August on these downgraded investments."
The three trustees -- Crist, state Chief Financial Officer Alex Sink and Attorney General Bill McCollum -- will also consider adopting more conservative investment guidelines and seek a top credit rating for the pool from Standard & Poor's. They will also discuss adopting new risk controls, building a larger reserve fund and improving daily pricing and performance measurement.
Word Spreads
About $19 billion remained in the pool this week after the unprecedented wave of withdrawals, which came after the State Board of Administration reported its holdings of downgraded debt to Crist at a Nov. 14 public meeting of his cabinet in Tallahassee. The disclosures followed a month of inquiries by Bloomberg News to Florida officials.
"Knowing other people were pulling out, and that word was spreading, we looked at the potential for a run on the pool," said Orange County's Moye.
The board in its statement tonight said the pool hasn't made any purchases of asset-backed commercial paper in November and "expects the total asset-backed exposure of the pool to be under 15 percent" by year-end.
Crist spokeswoman Jessica Graham said the governor wasn't available for comment. Coleman Stipanovich, the State Board of Administration's executive director, didn't return telephone calls seeking comment yesterday or today.
Pool Options
Should the withdrawals continue, Florida's pool may have to consider filing for bankruptcy protection, says John Coffee, a securities law professor at Columbia Law School in New York. "A bankruptcy could handle these kinds of problems if they feel they'll become insolvent," he said.
Coffee predicts the pool will likely file lawsuits to recover losses. "I'd expect the pool is going to sue the people who sold them the commercial paper, saying the risks were hidden," he said.
Lehman Brothers Holdings Inc. sold Florida most of its now- default-rated asset-backed commercial paper. Lehman spokesman Randall Whitestone declined to comment.
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 from highly rated banks.
The Florida pool, which was the largest of its kind in the U.S. at $27 billion before the recent spate of withdrawals, has invested $2 billion in SIVs and other subprime-tainted debt, state records show. Connecticut, Maine, Montana and King County, Washington, are among other governments holding similar investments, in smaller quantities.
Downgrades
The Florida pool's $900 million of defaulted asset-backed commercial paper now amounts to almost 5 percent of its holdings. The paper, which carried top ratings from S&P, Moody's Investors Service and Fitch Ratings as recently as August, was downgraded after declines in the value of collateral affected by the subprime mortgage slump.
The pool owns $168 million of debt from KKR Atlantic Funding Trust cut to D, or default, from B by Fitch Ratings on Oct. 8. It also has $356 million issued by KKR Pacific Funding Trust, cut to D from B by Fitch Ratings on Oct. 2. Fitch said the cut to default on the debt reflected non-payment under the original terms. The debt was restructured to extend the maturities to February and March, and interest payments are continuing.
Ottimo, Axon
Florida's pool has another $180 million of paper from Ottimo Funding, cut to D from C by S&P on Nov. 9. S&P said an auction of Ottimo's collateral "did not generate cash proceeds" to repay the asset-backed commercial paper. The pool also holds $175 million of short-term debt issued by Axon Financial Funding, an SIV. It was cut to D from C by S&P yesterday. S&P said Axon failed to pay liabilities maturing Nov. 26, causing an "automatic liquidation event."
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, some SIVs didn't have the cash to pay debt holders.
`Disappointment'
At Crist's Nov. 14 cabinet meeting, Stipanovich said that while there was "disappointment" over recent downgraded investments, no local government had ever lost money in the pool since its creation in 1982.
"I want Orange County to be first in a lot of things, but I don't want Orange County to be the first to lose money in the state's Local Government Investment Pool," said Martha Haynie, the county's comptroller, in an interview today.
Stipanovich also assured Crist and Sink at that time that the pool maintained the confidence of its depositors.
"There are a lot of rumors flying around," testified Stipanovich. "I'm not aware that there have been any material outflows."
Moye said Orange County pulled out of the pool this month because the State Board of Administration failed to provide adequate or timely disclosure to pool participants about its troubled investments.
Pinellas Withdrawal
On Nov. 20, Pinellas County pulled its entire $300 million from the pool.
"My first job is to safeguard principal," said Ken Burke, Clerk of the Pinellas Circuit Court. A certified public accountant, Burke controls the county's cash. He said a quarterly newsletter for pool participants, published Nov. 1, which mentioned downgrades but not defaults, wasn't candid about the pool's predicament.
"If some bad news comes out, the first thing I'd do is contact my customers and give them my side. The newsletter didn't tell us the full story," said Burke. "It made it sound like a bump in the road."
Neither the newsletter nor Stipanovich's testimony disclosed that the pool owns $650 million of certificates of deposit from Countrywide Bank FSB, a unit of Countrywide Financial Corp., that now amounts to more than 3 percent of the pool's assets. The bank's rating was cut to Baa1, three levels above junk, by Moody's on Aug. 16.
Liquidations
When local governments withdraw funds from the pool, the state must sell off holdings to raise the cash. Because Florida's pool has been forced to quickly raise billions of dollars to meet withdrawal demands, it won't get top dollar for its asset sales, says Joseph Mason, professor of finance at Drexel University.
"When funds like this are liquidated, the Street will take advantage of their desperation. They don't care if you're a hedge fund or a school district," said Mason, who completed an 18-month appointment as a scholar in residence at the Federal Deposit Insurance Corporation in January.
Mason, who has studied the history of bank failures, understands the rush by Florida municipalities to pull their money from the pool.
"The first people in the withdrawal line get 100 percent of their money," he said. "The loss is suffered by the people behind them in line. Since nobody wants to be at the end, you get a run on the pool."
Potential Losses
Mason says while the state of Florida has a moral duty to cover any losses suffered by the pool participants, its own shaky finances will make that difficult. The fourth most- populous state, hurt by the housing slump, cut its revenue projections by 3.9 percent for the fiscal year ending June 30, and 5.2 percent for the following year.
"The state appears to have breached the trust of the investors by putting money in new kinds of debt its managers didn't fully understand, in their search for higher yields," Mason said.
The Wall Street Journal, meanwhile, writes about foreigners with a similar yen for irresponsible behavior in "Woes Know No Border."
IKB's Hit Worsens In Germany; A Loss in Norway
Banks and investors in Germany and Norway are facing new losses from exposure to U.S. subprime mortgages, highlighting how credit problems continue to seep into places far afield from the U.S.
In Frankfurt yesterday, German bank officials held a crisis meeting to examine the deteriorating condition of IKB Deutsche Industriebank AG, whose push into U.S. bond investments left it facing such funding shortfalls in late July that it required an emergency bailout.
And in Oslo, a securities firm that sold clients securities tied to U.S. municipal bonds designed by Citigroup Inc. said it would file for bankruptcy after Norway's credit regulator revoked its license.
The German Finance Ministry will face tough challenges with IKB, a middle-market lender. Last month, bank officials thought the problems were contained, but they discovered new issues as IKB prepared to report its first-half financial results Friday.
State-owned financial company KFW Group this week said it had nearly doubled provisions for potential losses at IKB's affiliated fund to €4.8 billion ($7.12 billion) from the €2.5 billion it provided in August. More money may be needed to shore up deteriorating assets, some of which IKB holds. Yesterday's meeting was held as German banks, which already have anted up €1 billion, may be asked for more.
KFW -- 80% of whose shares are held by the Federal Republic of Germany -- plans a meeting of its board Friday, according to a person familiar with the matter.
IKB's losses stem from an affiliated fund that issued short-term debt and invested in longer-term securities. The affiliate, Rhineland Funding Capital Corp., landed IKB in trouble last summer when the market dried up for the short-term loans, commercial paper, and IKB couldn't cover the losses and debt from Rhineland. Those problems were one of the early signals of the global credit crisis.
The new problems appear tied to the decrease in values for some securities last month. Ratings agencies, citing borrower problems, downgraded mortgage securities and debt pools known as collateralized debt obligations that owned the securities. That forced the world's major banks to write down billions of dollars of securities.
In a statement Tuesday, KFW said: "Crucial new information that is of material relevance to valuation has come to light with regard to the Rhineland risks. In addition, the latest capital market developments have led to a dramatic worsening of the fundamental market assessment of the actual default risks in the subprime segment."
Representatives of the banks involved in the talks declined to comment on yesterday's meeting.
Problems in Oslo underscore how the troubles that hit IKB ultimately spread to other corners of the credit market.
Four Norwegian communities owned securities linked to a U.S. municipal-bond fund. The communities -- Rana, Narvik, Hattfjelldal and Hemnes -- borrowed money to invest in the securities, which were designed by Citigroup and sold to the communities by Norwegian firm Terra Securities, an arm of Terra Gruppen AS. The total investment was about 850 million Norwegian kroner, or some $156 million.
But those investments, made in June before credit problems had turned into a crisis, soured. The securities, sold by Terra, were linked to a U.S. municipal bond fund. Those losses were magnified because the communities had borrowed money to invest.
Yesterday, Terra Securities said it would file for bankruptcy after Norway's credit regulator revoked its company license.
The U.S. municipal bond market has seen a drop in prices in recent weeks because of concern about bond insurers. Those price declines were driven by the fact that if the insurers were downgraded, that could lead to downgrades of the bonds they insure.
Citigroup said the bank structured municipal portfolio fund-linked notes for Terra Securities and that Terra distributed the notes to its clients. Citigroup said it believed that the risks of investing in the notes were described in the materials provided to Terra.
Terra Securities said the products it sold to the four municipalities generated good returns until the market downturn.
Mark my words: the bad news about bagholders has only just begun.
Why in the world were municipalities borrowing to invest? That is completely insane!
Posted by: Smoove D | November 28, 2007 at 10:45 PM
This sounds like Orange County, CA circa 1994 all over again. The Local Government Investment Pool might indeed go bankrupt. Who knows how many other entities in Florida it may drag down with it? If politicians had been more concerned about the developing real estate bubble a few years ago and less concerned about stopping gay marriage, many of these financial problems might have been avoided. Now we all get to pay the price, but some will pay a lot more than others and many thousands of Americans, from Florida to California may even lose their homes.
Posted by: Rocky | November 29, 2007 at 10:37 AM