Subprime pain sweeps the world

More than 100 local councils, charities, churches, hospitals and nursing homes across Australia are sitting on a $2 billion black hole after buying subprime investments structured by Wall Street banks during the bull market but which are now potentially worthless.

Melbourne’s Metropolitan Ambulance Service and local councils are among those facing losses of hundreds of millions of dollars in the subprime meltdown because of bad debt they bought through a global investment bank.

A document leaked to BusinessDay revealed that Lehman Brothers is managing tens of millions of dollars in funds for Victoria’s community, education and health sectors, much of it invested in high-risk financial instruments now potentially worthless.

Other Victorian entities with millions in subprime exposure are not-for-profit defence personnel insurer Defence Health, which has $39 million managed by Lehman Brothers, and $17 million for the Victoria Teachers Credit Union.

BusinessDay has identified more than 150 government, private and charitable institutions that bought complex financial instruments such as collateralised debt obligations (CDOs). There have been few buyers for CDOs and similar structured finance products since the subprime meltdown this time last year that sent global financial markets into a tailspin.

These toxic investments will wreck the finances of many local government and charitable organisations for years.

Twenty-three local councils are preparing a class action lawsuit against Wall Street bank Lehman Brothers to recover their losses.

Among those that bought the products are four universities, dozens of super funds, ambulance services, the St Vincent de Paul Society, the Starlight Children’s Foundation, the Boystown charity for underprivileged children, and the Anglican, Baptist, Uniting and Catholic churches.

While not revealing the councils’ latest subprime exposure, the document showed East Gippsland Shire Council had $9 million managed by Lehman Brothers after the meltdown in banking markets, $6.5 million for Greater Shepparton and $5.5 million for the small Wellington Shire Council in central Gippsland.

Gosford Council, on the NSW mid-north coast, is sitting on a $74 million portfolio of CDOs and similar “structured finance” products, Newcastle Council $39 million, Coffs Harbour $39 million and Sutherland $55 million.

NSW and Western Australia are the states most affected, followed by Victoria, South Australia and, to a lesser extent, Queensland, whose investment rules require local councils to invest via Queensland Treasury.

National Australia Bank announced last month it was writing down the value of its CDO portfolio by $1 billion, or 90%, having deemed there was a high probability of a loss on the investments. Most of the charities and councils that hold CDOs are yet to make write-downs, and thereby concede that they will incur losses. Their problem is that the market for CDOs no longer exists. There are no buyers, although many councils claim their CDOs are still producing income and therefore remain a viable investment.

While the exposure of NSW councils has been the subject of an inquiry earlier this year by Platinum Asset Management chairman Michael Cole, the extent of the exposure held by other state and local governments, and charities, super funds, churches and other organisations has until now been unknown.

The list is long and includes co-operatives, teachers’ unions, credit unions, nursing homes, retirement villages, hospitals, listed public companies and state agencies.

Documents seen by BusinessDay confirm the exposure to CDOs is nationwide. The organisations in the table show Charles Sturt and Griffiths universities, Australian National University, Open University and the University of Western Australia are all exposed.

The CDOs were created by investment banks, which bundled thousands of US subprime home mortgages and sometimes even car and credit card debts into a complicated “derivative” security.

They were marketed as a safe investment, akin to a bond. The mix of the underlying home mortgage assets – “bricks and mortar” – was designed to minimise risk to the investor.

In most cases the banks that structured them acquired AA and AAA credit ratings from Standard & Poor’s or rival credit ratings agency Moody’s Investor Services by paying a fee.

When the US credit markets iced over last year and property prices plunged, investors were no longer willing to buy CDOs. The instruments’ very diversity worked against investors as no one could disentangle the product and its component parts: thousands of underlying mortgages packaged together.

The $2 billion in investments identified by BusinessDay pertains only to funds under Lehman Brothers management. Lehman acquired boutique local bank Grange Securities two years ago and Grange had been the biggest player in the CDO market, having undertaken a strategy of selling the product to local government, charity and semi-government agencies.

As Lehman was acting as “agent” to most of its council and charitable clients, it not only sold the products, it also managed them for clients, and in some cases “churned” the CDO portfolios by 200%, 300% and 500%.

In other words, the bank bought and sold the products between its clients and earned commissions on the sales, according to sources close to the councils.

It was able to charge higher fees as the CDOs were considered high-risk products although the councils claim they were not properly advised of the risk involved in the investments, nor of the prospect that there would be no “liquidity” or “secondary market” to sell them.

The CDOs were marketed with traditional Australian names such as Federation, Tasman, Parkes, Flinders, Kokoda, Kiama and Torquay. Some councils even took out loans to buy the CDOs, or sought “leverage” to magnify their returns. In these cases the losses would be deeper.

These Lehman portfolios, or “funds under management”, contained not only CDOs but other structured finance products such as capital protected notes and floating rate notes (FRNs) whose value is also difficult to establish.

Gosford Council, for instance, has $135.5 million in investments, most of which Lehman managed, but the face value of the CDOs and notes is $74 million. The CDO and note exposure of Hastings Council is $45 million from total investments of $82 million, Wingecarribee $32 million of $59 million and Sutherland $55 million from $123 million.

These figures are from late last year. They are not believed to have changed substantially.

Although Lehman Brothers is the biggest player in this CDO market, other banks also had a significant presence (our accompanying table represents only the Lehman funds under management post-credit meltdown – the figures may have changed in recent months).

While the collective exposure to Lehman may be less than $2 billion, there are hundreds of millions of dollars in CDOs and other structured finance products sold by other investment banks and promoters.

Even if 50% of the face value of these derivative investments could be recovered – and remember NAB recently wrote down the value of its CDO holdings by 90% – losses across the country from structured finance products may reach $2 billion.

Most of the holders can hardly afford any losses, particularly in the present economic climate where their income is coming under pressure.

The Cole report into local government exposure to CDOs and related instruments in NSW found that the book value of highly structured credit products in NSW alone was $590 million and the exposure to “capital guaranteed” products (also considered to be riskier than they sound) was $450 million from $5.64 billion in investments among 152 councils in NSW.

Further to the Cole findings, the Federation CDO series sold by Lehman/Grange had already fallen 85% in face value as of January this year.

The report found that NSW councils were down collectively $320 million on book value. Many held more than 45% of their assets in CDOs and FRNs.

That was January and globally investment product write-downs have more than doubled since then. Moreover, the valuations are considered conservative as they were in many cases guided by the product promoters.

Nor did the inquiry examine the exposure of other states and other bodies such as semi-government agencies and charities.

The first NSW council to take legal action has been Wingecarribee in the Southern Highlands. Piper Alderman, the law company acting in the matter, has now signed up 20 councils including Armidale, Blaney, Deniliquin, Gilgandra, Kiama, Narrabri, Parkes, Walcha, Wingecarribee, Port Macquarie and Carbonne.

Lehman Brothers declined to answer specific questions, but said it did not know about the class action and was defending a single action from Wingecarribee Council.

“Lehman Brothers will vigorously defend any legal proceedings commenced where we do not feel there is merit,” Lehman said.

“Lehman Brothers denies the claims Wingecarribee Council has made in its statement of claim filed with the Federal Court.”

Michael West
August 16, 2008

Source: The Age

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