O.C. FINANCIAL CRISIS : The Downfall of a High-Risk Fund : Wall Street Firms Defend Use of Derivatives and Downplay Risks
Wall Street went on the defensive on Friday, downplaying concerns about massive fallout from the Orange County investment fund’s troubles and defending the use of so-called derivative securities against another barrage of political criticism.
Merrill Lynch & Co. and Morgan Stanley Group, each of which has lent the $18.5-billion Orange County fund about $2 billion with which to buy bonds on credit, said their loans were fully collateralized and that they had no reason to fear losses.
And while the new chairmen of the Senate and House banking committees both said they would hold hearings on derivative securities in light of the Orange County fund’s losses, Wall Streeters noted that the fund’s problems were largely a result of its wrong-way bet on interest rates--not a surprise crash brought on by exotic derivatives.
One brokerage executive argued that “it’s almost irrelevant” that the fund owned $8.5 billion in derivative securities, because they were “garden variety” issues that represented the same basic bet on falling interest rates as the conventional longer-term bonds that comprised the rest of the portfolio.
“In this case, the derivatives give you the exact same result” as the conventional bonds, the executive said: The securities’ value plummets as interest rates rise. In Orange County’s case, the losses were worsened because the fund bought more than 60% of its assets on credit, he said.
While some other instances of derivative losses this year have involved thinly traded securities that became virtually worthless because of interest-rate shifts, analysts noted that the derivatives in the Orange County fund were mostly created out of bonds issued by U.S. agencies, such as the Federal Home Loan Mortgage Corp.
“These are all federal agencies (behind the bonds),” said another brokerage executive, requesting anonymity. “This is ‘money good’ at maturity,” assuming the fund can avoid selling them in the interim.
Indeed, Orange County officials have argued that their portfolio’s losses are no different from “paper” losses incurred by other bond investors this year as rates have risen, and that the fund simply needs to hold the securities until they mature to collect 100 cents on the dollar.
Even so, the extent to which the Orange County fund had purchased bonds on credit, and the high-risk nature of its bet--borrowing short-term to buy bonds maturing as far off as 1998--stunned many investment pros nationwide on Friday.
Some questioned why major Wall Street brokerages would facilitate such a strategy via credit, given that they knew that the Orange Countyfund was originally intended to be a short-term investment vehicle for taxpayers’ dollars.
“It’s shocking because what we’re talking about is an institutional money-market fund, holding cash that needs to be available on a short-term basis” to its investors, said one banking executive.
“I think it’s inexcusable for Wall Street to have allowed a public entity to do this,” another banking executive said.
Other critics noted that the “inverse floater” bonds that comprise the bulk of the Orange County fund’s derivatives, while plain-vanilla as derivatives go, still entail more risk than conventional bonds because they are structured to respond more violently to interest-rate moves.
But brokerage executives scoffed at the idea that Wall Street should be held accountable for a bad investment bet made by professionals who should have had full knowledge of the risks involved.
What’s more, some pros noted, the Orange County fund had used the same leveraged strategy to boost returns in 1991, 1992 and 1993, as interest rates fell and bonds appreciated.
“When you’re making money using risk, people don’t question it,” said Janet Grangaard, who manages $600 million in muni bonds for the Lutheran Brotherhood fund group in Minneapolis.
Nonetheless, the magnitude of the Orange County fund’s losses--$1.5 billion on paper, so far--has resurrected discussion within the brokerage industry and among regulators about the age-old issue of suitability: How can investors, large and small, be kept from hurting themselves unnecessarily with investments or strategies unsuitable for them?
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Richard Roberts, a Securities and Exchange Commission member, noted that the SEC several months ago asked six major Wall Street dealers in derivative securities to develop “voluntary suitability standards” that could serve as guidelines for investment firms and their investors. The dealers’ report is due Dec. 12.
R. Fenn Putnam, chairman of the Public Securities Assn., representing Wall Street bond dealers, argued that despite what is sure to be a renewed outcry in Congress about derivative investments, “We believe strongly that legislation (restricting derivatives’ use) isn’t the answer--education is.”
Derivatives, he noted, have been extensively and successfully used by investors worldwide for years to hedge as well as make bets on financial market trends.
* O.C. FISCAL FALLOUT
Investment review committee is formed while county’s bond rating is placed on watch. A1
