Subprime crisis catches charities and councils in maze of structured finance

The Herald revealed on Saturday - via leaked client information of the US investment bank Lehman Brothers - the extent of subprime exposures held by local councils, charities, churches, super funds, semi-government agencies and public companies across the nation.

Further, 20 councils have signed up for a class-action lawsuit claiming misleading and deceptive conduct by Lehman in selling them collateralised debt obligations (CDOs). Lehman said it would vigorously defend any actions.

We will get to the crux of these claims later, and an expanded treatment will run online, but a few points should be made first. The Lehman data shows that, far from being quarantined from the direct effects of the subprime collapse, Australia has been a dumping ground for fancy structured products such as CDOs and the damage is yet to be realised.

But these numbers ($2 billion exposure across Australia to Lehman funds under management, the bulk of which are CDOs) tell only half the story. Other banks, such as ABN Amro, Westpac, Deutsche, Macquarie and Morgan Stanley, have been involved in issuing CDOs.

There is also a slew of bombed-out CDOs listed on the Australian Stock Exchange.

Structured finance is a complex business, however, and in publishing the client list of one player in the market, it is fair to point out - not in the small print of the story this time - that the exposure of every client is different, in magnitude and by product.

Some products, such as the Federation CDO (referenced by US subprime mortgages), are commonly thought to be worth 10 per cent of their face value. Other exposures may be recovered.

The distinction also needs to be made between CDOs and floating rate notes (FRNs), which were the second most common asset class in the Lehman portfolios.

Two clients, the Victoria Teachers Credit Union and the credit union Mecu, held FRNs rather than CDOs in their funds managed by Lehman. Although the ASX ranks FRNs in the same asset class as CDOs, it is worth noting that most FRNs are not collateralised and are generally considered to be safer than CDOs.

Some are linked to CDO issues, and CDO issuers also issue FRNs, but the biggest credit risk with an FRN resides with the solvency of the underlying issuer. An FRN is, at its simplest, a promise to return capital at a later specified point in time, and pay some interest along the way.

Further muddying the waters swirling around the Lehman client accounts, the bank's law firm, Clayton Utz, said - in a letter threatening to seek an injunction over the publication of the documents - it had been instructed that the accuracy of some of the information (in the Lehman accounts) was doubtful.

Piper Alderman, the law firm signing up councils to the class action, has not yet decided whether to run its existing claim on behalf of Wingecarribee Shire Council alone or to join the other parties. Each party holds different assets and will have different versions of the representations made by Lehman.

In the Wingecarribee matter, it is alleged that Lehman made a number of representations - among them that the council's capital would be preserved - and that the bank bought and sold assets that were not in compliance with its investment mandate.

It further claims that Lehman still traded CDOs in its accounts with Lehman's other clients between February and July last year, without authorisation, and even though it should have been aware of the subprime problems emerging in the US. Lehman rejects the Wingecarribee claims.

Another claim is that the bank had described the Federation CDO (in a final term sheet that had not been provided to the council) as an Australian dollar floating rate note (an FRN, that is) linked to the performance of a portfolio of 40 AA- to A S&P-rated RMBS bonds backed by diversified US residential mortgaged pools.

Seeking to address the potential ballooning losses for its clients, Lehman had offered councils to switch out of Federation CDOs earlier this year into a bank-issued note that would return the council's original investment when it matured in 10 years.

The interest rate was about 1 per cent and the offer was rejected by many councils.

A few points for those evaluating the exposure of their council or any other investment manager: ask for a detailed account of the investments and all their fancy names. And when someone tells you they have not made a loss, assume that a loss is not a loss until the auditors and the board of directors deem it to be a loss.

One day last month the National Australia Bank had $1 billion worth of AAA-rated creditworthy CDOs. The next day they were worth 90 per cent less - and this is an institution followed closely by the nation's finest investment analysts.