CalPERS lost $1 billion on blind purchase

The level of trust, or gullibility, in the new global world of high finance before the meltdown last year is starkly revealed in a lawsuit filed by CalPERS against three credit-rating agencies.

CalPERS says that when it purchased $1.3 billion worth of special securities sold only to large investors like pension funds, all that it knew about the complex financial instruments is that they had top ratings from Moody’s, Standard & Poor’s and Fitch.

Now CalPERS, which may have lost $1 billion on the deal, has belatedly learned that there were subprime mortgages and other risky assets in the “structured investment vehicles” (SIVs) purchased in 2006 from three hedge funds, two of them based in London.

The English city with the medieval past brings to mind an old saying about buying a “pig in a poke.” Con men selling suckling pigs in sealed bags are said to have replaced them with inedible cats, hence “letting the cat out of the bag” reveals the scam.

A second lawsuit against the three rating agencies was filed Friday on behalf of several Ohio public pension funds who lost $457 million as high-rated securities went bust.

CalPERS won a first-round legal battle earlier this month when U.S. Federal Judge Susan Illston rejected a request by the three rating agencies to move the lawsuit from San Francisco Superior Court to the presumably less provincial federal court.

“The issue was whether CalPERS is or is not an arm of the state of California,” said Joseph Tabacco, an attorney for CalPERS, “and she determined that it is.”

Since the purchase of the securities from Sigma and Cheyne in London and Stanfield in NewYork three years ago, CalPERS has had a regime change, installing a new chief executive last year and a new chief investment officer this year.

The term of art for unidentified securities is that they are “opaque.” But the lawsuit filed last July under the new regime is quite clear about what happened from the CalPERS point of view.

“Only the SIV manager and the rating agencies knew what assets made up Cheyne, Sigma and Stanfield Victoria,” said the CalPERS lawsuit.

“The exact makeup of assets was treated as confidential lest anyone, even investors, learn CUSIP-level data of what was contained in the SIVs and be able to copy it. CalPERS justifiably relied on the ‘AAA’ ratings which persisted into 2007 and 2008, even as alarm over subprime mortgages grew.”

The lawsuit said that only about 28 SIVs were created, beginning in 1989. Growth spiked from 2005 to 2007, when 18 SIVs were created.

“According to a former consultant for Standard & Poor’s, SIVs came to be nothing more than a mechanism by which investment banks could move exposure to risky assets off their balance sheets,” said the CalPERS lawsuit. “In the consultant’s view, SIVs were the ‘end of the road’ for these assets.”

CalPERS was left holding the bag, said the lawsuit, when the three funds began defaulting on their payments “ resulting in hundreds of millions, and perhaps more than $1 billion, of investment losses for CalPERS.”

The lawsuit, similar to some post-crash stories in the national media, tells how the rating agencies once got most of their revenue from subscription fees paid by bond buyers and other investors.

But in recent decades the rating agencies began collecting fees from the issuers of bonds and other debt. When Wall Street went deep into “securitization,” particularly the bundling of mortgages, the agencies showed issuing firms how to get top ratings.

The CalPERS lawsuit said the rating agencies did not get full fees unless the complex debt instruments received a top rating and were sold. For a five-year period in this decade, Moody’s had the highest profit margin among S&P 500 companies.

A McClatchy news investigative report last month said Moody’s purged analysts and executives who questioned putting profits ahead of trustworthy ratings and promoted the loan packagers and securitizers.

During the credit boom, the rating agencies gave top ratings to many of the “toxic assets” that created the financial crisis. The CalPERS lawsuit says the rating agencies seemed to compete with each other to get business by giving good ratings.

Now lawsuits are being filed by a number of sore losers, not just pension funds in California and Ohio. One of the legal defenses used by the agencies is that their ratings are opinions, protected under free speech rights.

There were some stirrings of reform before the credit rating agencies became discredited.

State Treasurer Bill Lockyer launched a drive in March of last year urging the rating agencies to stop holding government bond issuers to a higher standard than corporations.

The treasurer said history shows that the government agencies are far less likely to default than corporations. He said the unwarranted lower ratings “cost taxpayers billions of dollars in higher interest rates and bond insurance premiums.”

Some rating agencies appeared to be considering Lockyer’s complaint, co-signed by 10 other state treasurers. But a Lockyer spokesman said movement stopped when the financial crisis erupted last fall.

In the wake of the crisis, there has been recent talk of creating competition or an alternative to the three rating agencies. The German government backed a proposal last month to create a new European-based credit rating agency.

“It revives an old chestnut in Europe where some policymakers want the dominance of three global agencies, Standard & Poor’s, Moody’s and Fitch, diluted by a home-grown rival,” Reuters news service reported on Oct. 28.

A man who founded a worldwide detective agency that specializes in corporate intelligence, Jules Kroll, has announced that he plans to launch an investor-funded rating agency next year.

Kroll made a pitch for support last month at a meeting in Los Angeles of the Council of Institutional Investors, an association of public and private pension funds with $3 trillion in assets.

He cited several examples of the private sector forming organizations to solve problems in banking, underwriting and purchasing without waiting for the government to act.

“As fiduciaries my plea to you is take charge of the situation,” Kroll told the council members. “Form your own consortium.”

Otherwise, he said, “I feel if organizations such as the institutions you represent do not do that, things will not materially change. There will be tinkering in Washington.”

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Posted 24 Nov 09

3 Responses to “CalPERS lost $1 billion on blind purchase”

  1. Dr. Mark H. Shapiro Says:

    The problem with the rating companies (Moody’s, S&P, and Fitch) was that they made their money from the companies selling the toxic securities. Thus, they had an incentive to give high ratings to securities for which the risk was either poorly understood or impossible to understand.

    The solution to this problem is obvious. Forbid the rating companies from deriving income from the issuers; and, instead, have them earn their money from the purchasers of securities. Then the rating company interests would be aligned with the purchasers of securities rather than the sellers.

    While some may say that this is impractical, it could easily be implemented by charging a very small fee (pennies) on each share of a rated security purchased.

  2. Peter Says:

    After Sarbanes-Oxley passed early in this decade, The Wall Street Journal published an editorial that traced the legislation to the erosion of trust in financial markets, and lamented the prospect for avarice driving more corruption, eroding whatever trust might be left, and requiring even more intrusive regulation. What a sad lot the human race is.

  3. Chriss W. Street Says:

    It is highly dubious to pretend that CALPERS did not know what they were buying. These securities had interest rates that differentiated better AAA from dicey AAA.

    The market for SIVs started in 1986 with Sigma. By 2006, there were over a trillion dollars of outstanding SIV medium term notes in the market. The Credit Crisis of 2008 was the equivalent of Katrina. People knew it could happen, but the odds were considered infintesimal. It happened!

    CALPERS has had wipe-outs in real estate, SIVs, Private Equity and securities lending. The rating agencies were not perfect by any measure, but CALPERS was the most aggressive player in the game.

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