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Subprime Investments

Recent turmoil in the credit markets has begun to expose the lack of disclosure and in some cases misleading sales presentations made by brokerage firms to their customer regarding the sale of Mortgage Backed Securities (MBS) or Asset Backed Securities (ABS).

In June 2007, Orange County based Brookstreet Securities was wiped out and forced to close its doors after its clearing firm National Financial reduced values in Collateralized Mortgage Obligations (CMOs) which caused accounts on margin to suffer markdowns and significant losses in customer accounts.

The lack of transparency in MBS, ABS and CMO securities has created a confidence crisis. Mortgage rating agencies including, Moody's, S&P and Fitch have recently moved to cut credit ratings exposing certain problems with MBS and ABS investments. On October 3, 2007 Fitch cut the credit ratings of $18.4 billion of bonds backed by subprime mortgages issued last year, citing an increased risk of default after an "unprecedented" slump in home prices.

The downgrades of the 1,003 bond classes represent 11 percent of the entire $173 billion of securities from 2006 that were rated by Fitch, the company said today in a statement. Fitch reduced ratings on $6.6 billion of bonds backed by second-lien subprime mortgages.

Fitch, a unit of Paris-based Fimalac SA, began a review in July of every transaction containing mortgages to borrowers with poor credit after investors criticized ratings companies for failing to act quickly enough as home-loan delinquencies rose.

Defaults reached record highs and some securities dropped by more than 50 cents on the dollar. Fitch is the first of the three largest credit-rating services to review all securities with debt arranged last year.

U.S. senators in Washington last week faulted credit ratings companies for grading subprime-mortgage securities too highly. The U.S. Securities and Exchange Commission said it is probing whether the firms were "unduly" pressured by Wall Street and a shareholder filed suit in New York accusing Moody's of not revealing it gave out inflated ratings.

Moody's Investors Service has downgraded or placed on review 496 bonds backed by first mortgages issued last year, or 3 percent of the total, including $5.3 billion of bonds backed by subprime loans.

Moody's said last month it expects to downgrade more subprime-mortgage securities, and will assume its ratings for many such bonds issued since July 2005 are too high in assessing new collateralized debt obligations. CDOs package pools of mortgage securities and slice them into pieces with varying degrees of risk, from AAA to unrated portions.

Through Sept. 21, Standard & Poor's had cut ratings on 433 of the securities issued last year and backed by subprime loans, or 9.1 percent of the total.

Fitch said it was "most concerned" about second-lien loans, which rank behind the first-mortgages in terms of payment.

Subprime Money Market Funds

Columbia Management, a unit of Bank of America Corp., has closed its Strategic Cash Portfolio amid losses on asset-backed securities. According to the Wall Street Journal, the fund is currently valued at $12 billion, down from $40 billion just months ago. Bank of America closed this fund just weeks after announcing that it had set aside $600,000,000 to cover potential losses on its money market funds and an institutional cash management fund.

The Strategic Cash Portfolio, considered an enhanced money fund, was offered exclusively to high net worth individuals and institutional investors with at least $25 million or more. The enhanced fund was sold as an alternative to money-market funds, considered among the safest of all investments.

Investors, largely concerned with the crumbling subprime market, began pulling money out of the fund beginning in August 2007. Withdrawal requests continued until the fund was no longer able to sustain itself. Upon its closing, the fund's share price was reported to be 99.4 cents on the dollar.

According to Bank of America, investors are left with two options. The largest investors will be redeemed "in kind"-given their share of the underlying securities in lieu of a cash payment. Smaller investors will be able to cash out at the 99.4 cents on the dollar current share price.

The Strategic Cash Portfolio is not the only enhanced money fund experiencing pressure from the continuing subprime crisis. Another enhanced money fund, the GEAM Trust Enhanced Cash Fund, managed by GE Asset Management, saw similar losses just a month ago due to investor concerns over the investments held by the fund. Investors in the GEAM fund were able redeem their position at 96 cents on the dollar.

Similarly, SEI, Wachovia/Evergreen Investments, Credit Suisse Asset Management, U.S. Bancorp/FAF Advisors, and Legg Mason separately announced that each had set aside funds or purchased losing investments from their funds to support their money market funds. Most have reported that such actions were necessitated by poor performing investments in special investment vehicles ("SIVs").


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