Monthly Archives: April 2009

State Street Corp., the Boston-based financial services firm that has made more than $4oo million in settlements and other payments for problems related to its fixed-income funds, is once again in hot water. This time, Massachusetts Secretary of State William Galvin is investigating whether State Street intentionally misled pension funds and other institutional investors about a bond fund that invested in high-risk derivatives, swaps and subprime-mortgage securities.

As reported April 30 by the Boston Globe, the State Street Limited Duration Bond Fund was supposed to be a way for investors to generate better returns than ultra-safe money market funds, but with only slightly more risk. Instead, the fund invested heavily in risky mortgage-related products, which later plummeted in value when the subprime mortgage market collapsed.

Making matters worse: The State Street Limited Duration Bond Fund was highly leveraged, borrowing money as it made continued investments in mortgage-backed securities. Eventually the strategy created even bigger financial losses for the fund.

State Street is the target of several lawsuits by investors who say the company hid the risks associated with the Limited Duration Bond Fund. On April 8, the Sisters of Charity of the Blessed Virgin Mary, based in Dubuque, Iowa, sued State Street, accusing it of putting their money in subprime mortgage products instead of the more conservative investments State Street’s financial advisors initially had promised. 

The nuns say they have lost more than $1 million of their retirement fund in the Limited Duration Bond Fund.

The Limited Duration Bond Fund is managed by State Street Global Advisors, State Street’s investment arm.

State Street also is at the center of a 2007 lawsuit filed by Prudential Financial, which claims the firm deceived the insurer by investing in products whose returns were linked to high-risk subprime mortgage pools.

William Hunt, CEO of State Street Global Advisors, abruptly resigned from his post in early 2008, just as the company began to face a slew of investor lawsuits relating to State Street’s subprime losses.

Oppenheimer Funds, one of the bigger players of 529 college savings plans with $4 billion under management, has been sued by the state of Oregon for gambling on exotic derivatives in the Oregon 529 College Savings Network. Oppenheimer’s ill-fated bets eventually resulted in $36 million in losses. 

In the complaint filed April 13, Oregon contends that Oppenheimer Funds made aggressive and inappropriate investments with the Oppenheimer Core Bond, yet described the fund as a “conservative” and “ultraconservative” plan. In filing the lawsuit against Oppenheimer, Oregon becomes the first state in the nation to sue the money manager on behalf of investors in its 529 college savings plan.

According to an April 14 article in the Wall Street Journal, the Oppenheimer Core Bond fund made significantly riskier investments beginning in late 2007 or early 2008. Ultimately, those risks translated into the fund losing more than 35% of its value in 2008, plus another 10% in the first three months of 2009. By comparison, the fund’s benchmark, the Barclays Capital Aggregate Bond Index, gained 5% in 2008 and has held even this year, according to the complaint.

The investments that Oppenheimer Funds gambled on included exotic instruments and high risk debt, all of which would be considered unsuitable for individuals saving for college, says the complaint.

Total return swaps and credit default swaps further added to the massive financial losses experienced by the Oppenheimer Core Bond Fund. Specifically, the Core Bond Fund entered into agreements with companies such as Lehman Brothers, American Insurance Group (AIG), Merrill Lynch, Citigroup and General Motors, agreeing to cover losses if they defaulted on their bonds. When those companies began to experience financial difficulties, with some, like Lehman Brothers, forced to file bankruptcy, the Oppenheimer Core Fund’s liability, and losses, became huge.

Four other states: Illinois, Texas, New Mexico and Maine, have sustained similar losses in their Oppenheimer Funds managed college savings plans. They also are considering lawsuits.

When the small town of Lewisburg, Tennessee, needed help paying the interest on a bond for new sewers, officials thought investment firm Morgan Keegan had the answers. Little did they know that the advice and the poorly conceived municipal bond derivative deal Morgan Keegan came up with eventually would mean millions of dollars in unanticipated costs, leaving Lewisburg and other municipalities like it financially devastated. 

Lewisburg is just one of a number of cities in Tennessee that has found itself burned by municipal bond derivatives and the advice of Memphis-based Morgan Keegan. Today, instead of lower interest rates on its sewer bond, Lewisburg is looking at annual interest payments that have quadrupled to $1 million, according to an April 7 article in the New York Times.

Officials in Lewisburg say when they first entered into the transaction with Morgan Keegan, they never realized the possible ramifications of municipal bond derivatives and the fact that interest rates could skyrocket depending on economic conditions. When the inevitable happened and the economy went south, Lewisburg quickly got a dose of its new reality.

According to the New York Times story, at the time Lewisburg sought the advice of Morgan Keegan, regulations in the municipal bond marketplace were so lax that in Tennessee the investment bank dominated virtually every component of the derivative business. Since 2001, the firm has sold $2 billion worth of municipal bond derivatives to 38 cities and counties.

The predicament facing cities like Lewisburg has led federal regulators to now consider restricting the use of municipal bond derivatives altogether. That news is of little comfort, however, to Lewisburg or Claiborne County, Tennessee, which has been trying to get out of its municipal derivative contract with Morgan Keegan for months. The cost to do so: $3 million, a sum that the already financially strapped county cannot afford.

As for Morgan Keegan, acting in the dual role of investment adviser and underwriter for transactions involving municipal bond derivatives has served it extremely well in Tennessee, with the investment bank raking in millions and millions of dollars in fees.

Municipal bond experts say there is an obvious bias when an investment firm like Morgan Keegan gives advice to municipalities regarding derivatives and then turns around to underwrite the deal itself. Several states, in fact, prohibit a single firm from acting in the role of both adviser and underwriter.

“It’s like the lion being hired to protect the gazelle,” said Robert E. Brooks, a municipal bonds expert and a professor of financial management at the University of Alabama, in the New York Times article. “Who was looking after these little towns?” 

A year of financial losses and investor lawsuits is about to go from bad to worse for Oppenheimer Funds. In February 2009, the company received an “F” from a Morningstar analyst for its failure to explain investing strategy changes regarding several of its bond funds. Now those funds, some of which have lost nearly 80% of their value, are the subject of probes by attorney generals in five states, as regulators investigate whether Oppenheimer Funds violated its fiduciary duty to investors.

The focus of the inquiries apparently is on 529 college-savings plans that invested in the Oppenheimer Champion Income Fund (OPCHX), which fell nearly 80% in 2008, and the Oppenheimer Core Bond Fund (OPIGX), which lost 41% of its value. Also on the states’ investigation list: the Oppenheimer Limited Term Government Fund (OPGVX) and the U.S. Government Trust (OUSNX).

Beginning late last year, Oppenheimer Funds, which is a unit of Massachusetts Mutual Life Insurance Company, became the subject of several state investigations, including those in Illinois, Maine, New Mexico, Oregon and Texas, over huge losses in state sponsored college savings plans.

As reported April 7 by Bloomberg, investors have seen $85 million vanish in just Illinois’ state sponsored 529 college savings plan because of investments made by Oppenheimer Funds in risky mortgage linked securities. Making the situation even worse: Parents were never told by Oppenheimer management about the investments nor the added risks they were unknowingly subjected to.

Ultimately, however, it was more than just toxic securities that contributed to the financial losses in the Oppenheimer bond funds. Specifically, Oppenheimer managers also bought complex, off balance sheet swap contracts that, in turn, produced a leveraging effect on the funds. Those added risks, which again were never apparent nor communicated to investors, translated into additional financial losses for investors.

Illinois has now stopped all new bond investments with Oppenheimer Funds, according to the Bloomberg article. As for Oregon’s 529 plan, two Oppenheimer Funds’ offerings have been eliminated. Oregon also is taking steps to replace OppenheimerFunds as the plan’s manager when the firm’s contract expires on Dec. 31.

In 2008, Oppenheimer Funds’s bond funds lost an average of 29%. By comparison, the average decline for bond mutual funds was 7.9%, according to Morningstar.

Meanwhile, investors both in and outside college savings plans are taking their frustration regarding Oppenheimer Funds to court, filing class action lawsuits and arbitration claims. The common theme in their complaints: OppenheimerFunds marketed and sold several of its bond funds as conservative, relatively low risk, high income investments. In reality, that was never the case.

It’s official. The Financial Accounting Standards Board (FASB) has approved relaxing fair value, or mark to market, accounting rules, a move that gives banks leeway to assign a value to investments based on their own internal model of what the assets might sell for in the future rather than in current market conditions.

Revising the accounting standard will be a boost to banks, which stand to see a 20% or more gain in their quarterly operating profits. 

The FASB voted on easing the mark to market rule on April 2. 

Critics of the rule change say it will lessen the transparency of a company’s fiscal health and may encourage some institutions to inappropriately raise the value of certain assets to give the appearance of rosier balance sheets.

As for investors, without the early warning signs created by mark to market accounting, they could very well find themselves left in the dark when it comes to detecting potential problems of a particular financial market. If problems do arise, it may be too late for them to do anything about it. 

Nontraded real estate investment trusts (REITs) apparently are a subject of interest by the Financial Industry Regulatory Authority (FINRA). A March 30 article in the Wall Street Journal reported that the independent regulator of the securities industry is seeking information from a number of broker-dealers about their sales and promotion practices of the entities. 

According to the Journal story, a letter dated March 20 was sent by FINRA to an “unknown number of brokerages” requesting details about nontraded REIT sales, as well as cash and non-cash incentives. Included in the letter was a request for detailed information regarding each nontraded REIT offered for sale, the number of shares sold to customers, the number of customers who each nontraded REIT and their age groups.  

The nontraded REITs in question include those that are registered with the Securities and Exchange Commission (SEC) but not on an exchange or over-the-counter market. They also include private REITs, which are sold using an exemption to registration.  

FINRA also wants information from broker dealers about payout schedules of registered representatives, blank customer applications, and risk monitoring reports that were used to track any activity in nontraded REITs, according to the Wall Street Journal. 

Broker dealers have until April 13 to respond to FINRA’s request for information about their dealings with nontraded REITs.

Proposed revisions to the fair value accounting standard known as FAS 157 have garnered harsh criticism from those who say the changes are ambiguous and undefined, lack substance and will create further inconsistencies as banks assign value to some assets. 

Under current FAS 157 rules, three different valuation levels exist for banks to price their mark-to-market holdings. Level 1 assets have readily observable prices and trade in active markets. Level 2 assets do not trade actively nor do they have easily obtainable prices. Level 3 assets include the most problematic holdings, such as collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs) and other exotic derivatives created by prime and subprime mortgages.  

Level 3 holdings are considered illiquid, with market prices so scarce that companies use internal models to gauge their value. In other words, placing a value on these assets is subjective and largely depends on assumptions or opinions. For this reason, Level 3 valuation is often referred to as “mark-to-myth” or “mark-to-imagination.” 

The new proposals for FAS 157 assume that “inactive” markets are the same as “distressed” markets. Moreover, the revisions essentially would allow banks to move more hard-to-value assets into Level 3. This means a company will be able to “handpick” the most appealing value for its assets, while casting aside any that might cause them financial turmoil. 

The bottom line: The proposed amendments to FAS 157 appear to squash the intended purpose of fair value accounting altogether. 

The Financial Accounting Standards Board plans to vote on the revisions to FAS 157 on April 2.