100 agencies facing a $2b black hole

by Michael West | Aug 16, 2008 | Finance & Tax, Government

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

BusinessDay has identified more than 150 government, private and charitable institutions that purchased 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 began this time last year, sending global financial markets into a tailspin.

These toxic investments will decimate 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 who bought the products are four universities, dozens of superannuation 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.

Gosford Council, on the Central 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 councils to invest via the Queensland Treasury.

National Australia Bank announced last month it was writing down the value of its CDO portfolio by $1 billion, or 90 per cent, 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 writedowns and thereby concede 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 was the subject of an inquiry earlier this year by the chairman of Platinum Asset Management, Michael Cole, the extent of the exposure of other state and local governments, and charities, superannuation funds, churches and other organisations has until now been unknown. The list is long (see smh.com.au/business) and ranges from co-ops, teachers’ unions, credit unions, nursing homes, retirement villages and hospitals to listed public companies and state agencies.

Documents seen by BusinessDay confirm the exposure to CDOs is nationwide. Charles Sturt and Griffith universities, the Australian National University, Open Universities Australia and the University of Western Australia are all exposed, as are the Metropolitan Ambulance Service, St Lukes Medical, Benalla & District Memorial Hospital, Western Health (Victorian hospitals) and the Royal Far West Children’s Health Scheme.

The CDOs were created by investment banks, which bundled up thousands of US subprime home mortgages into complicated “derivative” securities. 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 the risk to the investor. In most cases the banks were able to acquire AA and AAA credit ratings for them from Standard & Poor’s or Moody’s Investors Service 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 and their very diversity worked against investors as nobody 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 the funds under management of Lehman Brothers.

Lehman had acquired the 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 but also managed them for clients and in some cases “churned” the CDO portfolios by 200 per cent or more. 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 has $135.5 million in total investments, most of which were managed by Lehman, 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 Shire Council’s is $32 million from $59 million and Sutherland’s is $55 million, from $123 million.

Although Lehman Brothers is the biggest player in this CDO market, other banks also had a significant presence (the accompanying table only represents the Lehman funds under management post the 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 that have been sold by other investment banks and promoters.

Even if 50 per cent of the face value of these derivative investments could be recovered, the likely losses across the country from structured finance products may reach $2 billion.

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

Further to the Cole findings, the “Federation” CDO series sold by Lehman/Grange had already declined 85 per cent in face value as of January this year. NSW councils, the report found, were down collectively $320 million on book value. Many held more than 45 per cent of their assets in CDOs and FRNs. That was in January. Since then, global investment product writedowns have more than doubled. Moreover, the valuations are considered conservative, as investors were in many cases guided by the product promoters.

The first NSW council to take legal action has been Wingecarribee, in the Southern Highlands. Piper Alderman, the law firm that is acting in the matter, has signed up 22 other councils in a class action.

Lehman Brothers declined to field specific questions but said it did not know about the class action and was presently 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 Brothers denies the claims Wingecarribee Council has made in its statement of claim filed with the Federal Court.”

Michael West established Michael West Media in 2016 to focus on journalism of high public interest, particularly the rising power of corporations over democracy. West was formerly a journalist and editor with Fairfax newspapers, a columnist for News Corp and even, once, a stockbroker.

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