Sub Prime Risk and Collateralized Debt Obligations

This very lengthy piece in Bloomberg today is fascinating for the detailed insight it offers into how and why the sub-prime mortgage issue is unwinding the way it is:

Subprime Infects $300 Billion of Money Market Funds, Hikes Risk


Money market funds were invented 37 years ago to offer investors better returns than bank savings accounts while providing a high degree of safety. Most of the $2.5 trillion sitting in these funds is invested in such assets as U.S. Treasury bills, certificates of deposit and short-term commercial debt.

Unlike bank accounts, money market funds aren't insured by the federal government. They almost never fail.

Unbeknownst to most investors, some of the largest money market funds today are putting part of their cash into one of the riskiest debt investments in the world: collateralized debt obligations backed by subprime mortgage loans.

CDOs are packages of bonds and loans, and almost half of all CDOs sold in the U.S. in 2006 contained subprime debt, according to a March report by Moody's Investors Service.

U.S. money market funds run by Bank of America Corp., Credit Suisse Group, Fidelity Investments and Morgan Stanley held more than $6 billion of CDOs with subprime debt in June, according to fund managers and filings with the U.S. Securities and Exchange Commission. Money market funds with total assets of $300 billion have invested in subprime debt this year.

The danger of owning even highly rated CDOs containing subprime loans was thrown into sharp relief in June, when two Bear Stearns Cos. hedge funds that were holding subprime CDOs collapsed.

Bear Stearns Manager

At the center of that storm was Ralph Cioffi, a senior managing director at Bear Stearns who ran the hedge funds. Cioffi, 51, wore another, less publicized hat. He managed more than $13 billion of CDOs, according to Fitch Ratings -- and money market funds and other investors bought all of it.

Cioffi-managed CDOs filled with subprime debt have been purchased by money market funds run by Invesco Plc's AIM Investment Service, Marsh & McLennan Cos.' Putnam Investments and Wells Fargo & Co.

In August, New York-based Bear Stearns fired Warren Spector, the firm's co-president for fixed income and asset management. Cioffi stayed with the bank. Bear Stearns spokesman Russell Sherman says Cioffi's stewardship of the bank's CDOs ended in late June.

``There is a team of portfolio managers running them now,'' Sherman says. ``Ralph still serves as an adviser.'' Cioffi didn't respond to telephone and e-mail requests for comment.

Under SEC rules, money market managers must invest in securities with ``minimal credit risks.'' Joseph Mason, a finance professor at Drexel University in Philadelphia and a former economist at the U.S. Treasury Department, says subprime debt in money market funds is far from safe.

`Tremendous Risk'

``This creates tremendous risk for today's money market investors,'' says Mason, who wrote an 84-page report on CDOs this year. ``Right now, I'm not comfortable investing anything in CDOs.''

Global financial markets were rocked in July and August, first by the collapse of the Bear Stearns hedge funds and then when banks and insurance companies worldwide disclosed their U.S. subprime debt holdings.

On Aug. 9, BNP Paribas SA, France's biggest bank by market value, froze withdrawals on three investment funds with assets of 2 billion euros because the bank couldn't find a way to value its U.S. subprime bonds and other assets. CDOs aren't bought and sold on exchanges and their trading has little transparency.

During the first two weeks in August, central banks in Europe, Japan and Australia and the U.S. Federal Reserve lent more than $300 billion to banks to stem a collapse in credit markets.

On Friday, the Federal Reserve lowered the interest rate it charges to banks to 5.75 percent from 6.25 percent in an attempt to contain the subprime mortgage collapse.

`It's Inappropriate'

Money market funds have become a staple for investors. There are 38.4 million money market fund accounts in the U.S., according to the Investment Company Institute.

People use a money market both to hold savings and serve as an account to buy securities and place the proceeds of sales. Bruce Bent, who in 1970 created the first money market fund, The Reserve Fund, says no money market fund should invest in subprime debt.

``It's inappropriate,'' Bent, 70, says. ``It doesn't have a place in money market funds. When I created the first money market fund, I said you have to have immediate liquidity, safety and a reasonable rate of return. You also have to have a situation where you're not giving people headline risk.''

Seeking Safety

Investors have sought safety during the subprime meltdown by moving their holdings to U.S. Treasuries and money market funds. On Aug. 8, just after the Bear Stearns hedge funds filed for bankruptcy protection, U.S. money market fund total assets reached a record high of $2.66 trillion, with investors pouring $49 billion into such funds in one week, according to the ICI.

As a sign of stability, money market funds never allow their share price to rise above or fall under $1 for each dollar invested.

A money market fund that invests in subprime debt increases the risk that its share price could drop below $1. If 5 percent of a fund's holding is subprime debt, and in a worst-case situation that asset collapses, then the value of the fund could drop to 95 cents.

Even if a fund's value dropped below a dollar, banks and fund companies wouldn't allow investors to lose money, says Peter Crane, founder of Crane Data LLC, the Westborough, Massachusetts-based publisher of the Money Fund Intelligence Newsletter.

`Virtually Nil'

``Fund companies will support the funds,'' he says. ``They won't let them break $1 a share. The odds of money market funds breaking the buck are virtually nil.''

Just once has a money market fund failed. In 1994, a fund run by Community Bankers Mutual Fund of Denver invested in securities that defaulted. Investors were paid 96 cents a share, and the fund was liquidated.

The fund had invested 27.5 percent of its assets in adjustable-rate securities, whose values were tied to interest rate changes, the SEC found. The fund lost money as interest rates increased.

Until recently, CDOs had been the fasted-growing debt market -- outpacing corporate and municipal bond sales by dollar total -- with about $500 billion sold in 2006, up from $99 billion in 2003, according to Morgan Stanley.

CDO Slump

About a quarter of the content of all CDOs sold last year in the U.S. was made up of securitized subprime mortgage loans. CDO sales slumped to $11.9 billion in July from $36.9 billion in June, according to JPMorgan Chase & Co.

SEC Chairman Christopher Cox told Congress in June his agency was conducting about a dozen probes related to the marketing of subprime CDOs to investors.

Lynn Turner, chief accountant of the SEC from 1998 to 2001, says the SEC will likely look into money market funds investing in CDOs, particularly because the value of subprime collateral of CDOs can collapse suddenly.

``I'm betting some people at the SEC will be concerned,'' he says. ``And they'll be more concerned in six months. How quickly did the Bear Stearns hedge fund evaporate?''

Each time a bank or financial firm creates a CDO, it forms a free-standing company incorporated offshore, usually in the Cayman Islands, which doesn't tax corporations. All CDOs have a trustee, usually a bank, that prepares monthly reports on the changing contents of the debt package.

From Mortgage to Fund

The trail that connects subprime debt to money market funds usually starts with a mortgage broker who makes a loan to a homebuyer with poor credit. A middleman then bundles hundreds of these subprime mortgages into so-called asset-backed securities.

Next, a CDO manager buys hundreds of these securities for collateral for a CDO. Some CDOs issue commercial paper, and brokers can then sell that paper to money market funds. Commercial paper, which is typically issued by banks and large companies, is debt maturing in less than 270 days.

Commercial paper pays relatively low interest rates, which averaged about 5.3 percent in June and July, because it rarely defaults. There have been occasional exceptions, such as paper issued by Enron Corp. and WorldCom Inc., both of which filed for bankruptcy earlier in this decade.

CDO commercial paper, often loaded with subprime debt, pays higher returns than corporate paper, and it paid as much as 6.5 percent in August.

This year, CDOs have sold more than $11 billion in the form of investment-grade commercial paper to money market funds, SEC filings show. The paper has the highest credit rating because Fitch Ratings, Moody's and S&P give AAA or Aaa ratings to the top portions of CDOs, which are the source of all CDO commercial paper.

`An Unpleasant Surprise'

Satyajit Das, a former Citigroup Inc. banker and author of 10 books on debt analysis, says those ratings are very misleading. ``I don't think the typical money market investor, in his wildest dreams, would assume he has exposure to the risk of subprime CDOs,'' he says. ``They may be in for an unpleasant surprise.''

Money market managers buy CDO commercial paper even when prospectuses warn of the risks.

Zurich-based Credit Suisse, Morgan Stanley in New York and San Francisco-based Wells Fargo are among money market managers that poured more than $1 billion into commercial paper issued by the Buckingham series of CDOs managed by Chicago-based Deerfield Capital Management LLC.

`Do Not Exist'

``Reliable sources of statistical information do not exist with respect to the default rates for many of the types of collateral debt securities eligible to be purchased by the Issuer,'' say both the 2005 and 2006 CDO prospectuses backing commercial paper held in the funds.

Deerfield's three Buckingham CDOs have directed $1.5 billion, or 40 percent of their $3.8 billion in assets, into subprime debt, according to their trustee reports. Billionaire Nelson Peltz's Triarc Cos. agreed to sell Deerfield in April.

Morgan Stanley spokesman Mark Lake and Wells Fargo's John Roehm declined to comment.

Tim Wilson, head of Credit Suisse's cash management portfolio desk, says he's comfortable with CDO commercial paper because it has the highest credit ratings and because his funds hold the debt for only one to three months.

`We're Watching'

``We don't have any concerns these are going to have any defaults in 90 days,'' he says. ``We're obviously watching.'' The paper matures within three months, and after that the fund doesn't hold any subprime debt, unless Wilson decides to buy more.

Vanguard Group Inc., the second-largest mutual fund company in the U.S., has a policy of never buying CDO commercial paper for its $90 billion in money market funds or $325 billion in fixed-income mutual funds.

``It really gets down to transparency questions,'' says John Hollyer, risk management director at Valley Forge, Pennsylvania-based Vanguard. ``Can you understand what you have? And can you measure it appropriately? We haven't been comfortable that we could.''

Bank of New York Mellon Corp.'s Dreyfus unit has banned CDO commercial paper from its $110 billion in money market funds because it has found that analyzing subprime holdings in CDOs is too difficult.

The firm's money market investment committee decided in 2005 that such paper was too risky, Dreyfus spokeswoman Patrice Kozlowski says. ``The committee questioned the fundamental structure of commercial paper of CDOs,'' she says. Dreyfus has never purchased CDO commercial paper, she says.

`Refuse to Fund'

CDOs create what is supposed to be a safety net for buyers of their commercial paper. CDO managers reach agreements with banks to purchase their paper when nobody else will, so the CDO can pay off debt when it's due.

Some fund companies, including Dreyfus, say those contracts don't reassure them because they're conditional and they aren't guarantees. ``The banks can refuse to fund,'' Kozlowski says.

CDO paper has other risks, former banker Das says. ``CDO commercial paper has a lot more moving parts than other kinds of commercial paper,'' says Das, who wrote ``Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives'' (FT Prentice Hall, 2006).

``There's a lot more that can go wrong,'' he says. Das says that because so much subprime debt is held by CDOs, there is constant risk that the value of the investment can drop or collapse.

The Credit Suisse Group Institutional Money Market Fund Prime Portfolio held 8 percent of its $22.8 billion of assets in commercial paper secured by subprime home loans as of June 30.

`It's There'

Fund manager Wilson says he's not worried about the $1.8 billion in subprime content because the term of the debt is so short. ``Lots of clients are uncomfortable owning commercial paper with `CDO' in the name,'' Wilson says.

He monitors his CDO holdings by analyzing the monthly reports that CDO trustees publish, listing all holdings. ``I think there are some investors not doing the work and relying on ratings,'' Wilson says. ``If you're willing to do the work, it's there.''

Credit rating companies don't just rate CDOs; they play an active role in assembling them, says Charles Calomiris, the Henry Kaufman professor of financial institutions at Columbia University in New York. Fitch, Moody's and S&P participate in every level of packaging a CDO, says Calomiris, who has worked as a consultant for UBS AG, Bank of America and Citigroup.

A CDO manager gathers hundreds of loan securitizations or bonds to use as collateral for the CDO. The debt supports an assortment of CDO sections, ranging from the riskiest non- investment grade to AAA or Aaa rated. CDO managers consult with analysts from the rating companies when creating a CDO, negotiating the highest credit ratings for each level, or tranche.

The Credit Raters

Most of the dollar value of all CDOs, as much as 90 percent, gets a credit rating of AAA or Aaa. The higher the credit rating, the lower the return that's demanded by investors. The CDO commercial paper bought by money market funds always has a top credit rating, even when it's backed by subprime debt.

In the past three years, Fitch, Moody's and S&P have made more money from evaluating structured finance -- which includes CDOs and asset-backed securities -- than from rating anything else, including corporate or municipal bonds, according to their financial reports.

The companies charge as much as three times more to rate CDOs than to analyze bonds, their cost listings show. The three rating companies say these fees are higher because CDOs are so complex.

Close Relationship

The close working relationships between CDO managers and rating companies -- and the fees that change hands -- mean money market funds shouldn't rely on ratings to evaluate CDOs, says Harvey Pitt, who was SEC chairman from 2001 to 2003.

Pitt says fund managers should do their own research on CDOs by reading the hundreds of pages of prospectuses and the monthly trustee reports. Some managers may not have been doing their homework.

``Relying on rating agencies for investment advice is dicey,'' he says. ``Their reliance on rating agencies left them a day late and several dollars short.''

Two money market funds run by AIM have gotten the message. They stopped buying CDO commercial paper. ``In today's market, you really can't trust any ratings,'' says Lu Ann Katz, AIM's director of cash management research.

As recently as June, two AIM money market funds owned $2.64 billion of CDO commercial paper that was invested in subprime debt. The debt made up 10.2 percent of the AIM STIT-Liquid Assets Portfolio and 4.5 percent of AIM STIT-STIC Prime Portfolio.

Mistrust of Ratings

Katz says she's stopped buying CDO investments because she doesn't trust credit ratings and she thinks CDO paper in money market funds is too risky. AIM's funds had included more than $1 billion of CDO commercial paper issued by CDOs managed by Bear Stearns before its hedge funds collapsed.

Fidelity Investments, the world's biggest mutual fund company, owned $2.3 billion in CDO-issued commercial paper in two money market funds as of May 31, according to spokeswoman Sophie Launay. The biggest money market fund in the U.S., Fidelity Cash Reserves Fund, had 1.5 percent of its $98.2 billion assets invested in CDO commercial paper backed by subprime debt.

The Fidelity Institutional Money Market Portfolio had 2.3 percent of its $32.3 billion in assets in such commercial paper. Boston-based Fidelity fund manager Kim Miller says he's holding off on buying more CDO debt.

`Dust to Settle'

``There's been a lot of volatility,'' he says. ``I think people are waiting for the dust to settle, and we're doing the same.''

Money market managers are required to determine that their investments are safe and have high credit ratings, according to Rule 2a-7, a 1997 addition to the Investment Company Act of 1940.

``The money market fund shall limit its portfolio investments to those United States dollar-denominated securities that the fund's board of directors determines present minimal credit risks,'' the rule says.

Money market managers buy CDO commercial paper to boost returns and make their fund more attractive to investors, which in turn increases their income, money market fund inventor Bent says. ``The higher rates sell more easily,'' he says. ``They're doing it to suck the people in.''

Fund managers are paid based on the total dollar amount invested in their funds, so more assets mean higher pay for managers.

``Trying to outguess the market makes no sense at all,'' Bent says about money market funds. ``That's not the risk you're looking for.''

Higher Yields

The subprime-backed commercial paper in money market funds offers some of the highest yields managers can include in their investments because such funds are prohibited by SEC rules from buying junk-rated debt.

The Bear Stearns hedge fund implosion demonstrated how misleading credit ratings of CDOs can be. The two funds had avoided buying the riskiest CDOs, sticking with tranches awarded AAA and AA grades, or the highest available, from Fitch, Moody's and S&P.

In July, the funds filed for bankruptcy protection as the investment bank halted withdrawals from a third fund, Bear Stearns Asset-Backed Securities Fund, after investors sought to extract their money.

Bear Stearns High-Grade Structured Credit Strategies Master Fund Ltd. and Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund Ltd. lost a combined total of about $1.5 billion in the second quarter as home prices slumped and subprime loan foreclosures jumped 62 percent from a year earlier because borrowers stopped making mortgage payments.

Cioffi

Cioffi had total control of Bear Stearns CDOs, according to a Fitch report dated Aug. 3. ``In lieu of a formal committee process, ultimate decision making lies with Ralph Cioffi,'' Fitch wrote.

Cioffi joined the bank as a bond salesman in 1985, seven years after earning a bachelor's degree in business administration at Saint Michael's College in Colchester, Vermont. Apart from his job managing funds, Cioffi also ran the Klio and High-Grade Structured Credit CDOs, which are rated mostly AAA.

AIM, Putnam, Wells Fargo and other fund managers bought more than $4 billion of Klio and High-Grade commercial paper backed by subprime home loans.

In June, the three Klio CDOs held 37-41 percent in subprime mortgage securities, according to trustee reports. The original $5 billion in collateral for Klio II's CDOs, purchased in 2004 and 2005, came from a source very close to home: Cioffi's own High-Grade Structured Credit Strategies Fund.

Low Risk?

AIM's Liquid Assets Portfolio held almost $900 million in Klio commercial paper on May 31, SEC filings show. Putnam Money Market Fund owned $119 million of Cioffi-managed paper on March 31, amounting to 3.5 percent of the Putnam fund's $3.41 billion in holdings.

``By investing in high-quality, short-term money market instruments for which there are deep and liquid markets, the fund's risk of losing principal is very low,'' Putnam wrote in its first-quarter report to shareholders.

``Putnam Money Market Fund holds a much smaller amount of CDOs than it did in March,'' Putnam spokeswoman Laura McNamara says. ``Putnam is comfortable with the structures we currently own.''

Seven money market funds run by Federated Investors Inc., the third-largest U.S. manager of money market funds, owned more than $1 billion of commercial paper issued by Bear Stearns- managed CDOs at the end of June, according to Federated's Web Site.

Not `Comfortable'

``We were never real comfortable with the whole program to begin with,'' says Deborah Cunningham, chief investment officer of Pittsburgh-based Federated's money market funds. ``We wanted to monitor it more and keep a little tighter rein on it.''

She says that's why Federated has never held Klio paper for more than 90 days.

Bank of America's Columbia Cash Reserves and Columbia Money Market Reserves funds owned more than $600 million of Bear Stearns's Klio CDO paper on June 30, according to Boston-based Columbia Management, the investment division of Bank of America, which is based in Charlotte, North Carolina.

``The funds are permitted to invest in asset-backed securities,'' Bank of America spokeswoman Faith Yando says.

Three Wells Fargo money market funds held $886 million in Bear Stearns-managed CDO commercial paper on June 30. The funds held a total of $1.5 billion in CDO commercial paper on that day, according to Wells Fargo spokesman John Roehm.

Trimming CDO Holdings

The Wells Fargo Advantage, Advantage Cash Investment and Advantage Liquidity Reserve funds held the subprime-backed debt. The funds' holdings of all CDO commercial paper ranged from 4.1 percent to 6.9 percent of their assets, Roehm says.

Wells Fargo trimmed its money market funds' CDO holdings to $680 million by July 31, Roehm says. He declined to comment further.

Wells Fargo money market funds also held more than $120 million of commercial paper issued by CDOs managed by Deerfield Capital Management on June 30. That CDO firm was controlled by billionaire Peltz, 65, who owns the Arby's fast-food chain and sold Snapple Beverage Corp. to Cadbury Schweppes Plc for $1.45 billion in 2000.

Peltz agreed on April 20 to sell Deerfield to an affiliate, Deerfield Triarc Capital Corp., a publicly traded real estate investment trust with no employees, for $290 million, SEC filings show.

Deerfield Triarc hired Bear Stearns in March for $2.4 million to provide a so-called fairness opinion, which concluded that the acquisition price was acceptable. Bear Stearns spokesman Sherman declined to comment on the fairness opinion.

SEC Inquiry

Deerfield Triarc disclosed in a July 13 regulatory filing that the SEC was conducting an informal inquiry into collateralized mortgage obligations and had made two information requests to Deerfield as part of its probe.

That filing was made more than two months after Triarc announced the sale of Deerfield Capital Management. Triarc noted the federal probe on page 21 of the filing as part of a list of risks for investors.

Peltz didn't respond to e-mail and telephone requests for comment.

Commercial paper from CDOs, laced with subprime home loan securitizations, made up 5.1 percent of the $11.4 billion Wells Fargo Advantage Money Market Fund as of June 30. The holdings included $96 million of Buckingham CDOs.

Morgan Stanley

Morgan Stanley money market funds held more than $330 million of Deerfield's Buckingham commercial paper on June 30, according to the bank's Web site. Credit Suisse money market funds owned more than $700 million in April, according to SEC filings.

The Morgan Stanley Institutional Liquidity Funds Prime Portfolio held $235 million of Buckingham commercial paper on June 30. Morgan Stanley spokesman Lake declined to comment.

Deerfield's CDO track record isn't reassuring. Since 2000, six of the 14 CDOs Deerfield manages have had tranches downgraded from investment grade to junk. Valeo Investment Grade I and II, Mid Ocean 2000 and 2001, Ocean View and North Lake include sections that lost their investment-grade ratings.

In May, Fitch said 39 percent of Mid Ocean CDO collateral was distressed, and it expected all of a $44 million Mid Ocean tranche to be a total loss. Moody's still rates Mid Ocean investment grade, or Baa3, one notch above junk.

Deerfield Capital Senior Managing Director John Brinckerhoff and Bear Stearns spokesman Sherman declined to comment.

Regulation

While CDOs aren't regulated by the SEC, mutual funds -- including money markets -- are. The SEC disclosed in June it's begun looking at some CDO investments, without releasing further details.

Former SEC Chief Accountant Turner says investors have cause to be concerned about money market funds' holding subprime debt. ``It doesn't make you feel real good in the gut,'' Turner says. ``This stuff takes on a life of its own when it starts going south.''

Investors are accustomed to treating money market funds as if they were bank savings accounts. The last thing they expect is that the subprime debt turmoil would enter their safe cash havens. And now it has.