Another week, another new and unlikely type of victim in the subprime-mortgage mess. As if the pounding received by banks, hedge funds, homebuilders, bond insurers and even discount brokers was not enough, the pain is spreading to usually sleepy corners of local government, thanks to state cash-management funds that were not quite as safe and liquid as advertised.
The fund at the centre of the latest debacle is Florida’s Local Government Investment Pool (LGIP), which is used by the state’s schools and municipalities for short-term investing and routine expenditures. Hungry for extra yield, it gobbled up several billion dollars of debt issued by structured investment vehicles (SIVs), which have investments in subprime mortgages and other asset-backed nasties that have won them pariah status.
Once the extent of this exposure emerged last month, and as rating agencies hastened their downgrading of SIV borrowings, nerves frayed. Panicky investors had pulled out $13 billion, nearly half of the fund’s assets, by the time state officials stepped in to freeze withdrawals on November 29th. This set off a firestorm of protest from school and municipal officials, who suddenly found themselves short of money to pay staff or utility bills.
On December 4th Charlie Crist, the state’s governor, approved a rescue plan forged with help from BlackRock, an investment firm. In an echo of the Treasury-backed rescue fund for SIVs, which is still being pieced together by Citigroup and other banks, the troubled assets, which BlackRock says are of “indeterminate” value, are being hived off into a distressed fund. The unblemished bit, 86% of the total, was poised to reopen, at least partially, on December 6th. Both parts will be managed by BlackRock until an outside manager is appointed.
The fiasco invites comparisons with California’s Orange County, which was responsible for America’s largest municipal bankruptcy in 1994 after losing $1.6 billion through ill-advised derivatives trades. In both cases, state-employed neophytes were seduced by complex products peddled by Wall Street—which is again likely to be hit with lawsuits as a result—and failed to appreciate the enhanced risks that come with enhanced returns. Unlike Orange County, however, Florida is no isolated case. More than two dozen American states, including Montana, Maine and Connecticut, run similar investment pools. Nine of them have direct investments in shaky SIVs, as do many county-level funds (including, once again, red-faced Orange County’s). Several have seen withdrawals, though not on the same scale as Florida. Municipalities overseas, from Norway to Australia, have also been caught out. Arthur Levitt, former head of the Securities and Exchange Commission, is urging states to step in and guarantee their investment pools.
All of which raises fresh questions about the more than $3 trillion parked in privately managed money-market funds. Considered ultra-safe before the credit crunch, even some of the best-run funds have shown signs of weakness as credit ratings have been revised. In more than two dozen cases, managers have had to shore up such funds to ensure they do not “break the buck”, causing investors to lose money. Despite all the hoopla, most investors are likely to get their money back, even from funds that dabbled in SIVs. Because the funds are short-term investors, they have been able to reduce their exposure to such vehicles quickly—by 40% in the two months to November, reckons Standard & Poor’s, a rating agency. Most SIVs are still honouring their debts.
Peter Crane, publisher of Money Fund Intelligence, argues that those who flee money-market funds for treasury securities are compounding the damage, because losses in forgone yield will, by and large, outweigh gains in terms of safety. For most short-term cash vehicles, “this is more of a headlines crisis than a real credit crisis,” he says. Try telling that to the school principals in West Palm Beach.