Shaky investment calls Treasurer’s skills to forefront

As a certified financial planner, I began warning my clients about sub-prime debt last March. I told them to sell or avoid funds that hold sub-prime investments. I also warned them to avoid high-yield funds that risk loosing value as investors were going to seek more secure investments. I did so because in February 2007 financial giant HSBC announced that they were taking a write off of $8.8 billion due to the decline in value of bonds they held that invested in sub-prime mortgage debt.

Sub-prime mortgages are the sorts of loans that were made to people with no down payment or with poor or spotty credit histories. Many of these loans are considered “predatory” because they were made with low “teaser” rates that increase dramatically after the first few years of the loan. The Maine Legislature wisely prohibited the most abusive of these predatory sub-prime mortgages earlier this year. The news that many of these loans were going bad should not have been a surprise, but it caused a financial shock in the bond markets. Traders on Wall Street could no longer find buyers for mortgage derivatives because the underlying holdings are backed by bundled mortgages – some of which were defaulting or going into foreclosure. By March the talk on Wall Street was whether or not the bond rating agencies’ rating of mortgage derivative securities could be trusted.

So, I was stunned to read last week that after all of this had happened in the spring that in early August the state of Maine invested $20 million worth of short-term tax receipts – that would be needed in 30 days – into a British hedge fund based in the Cayman Islands that invests in sub-prime mortgages. In August the sub-prime mortgage loan market – that had been collapsing since February – finally ground to a halt. The Federal Reserve was forced to act to rescue the bond market. At the same time the Bank of New York froze the holdings of the state’s short term $20 million investment because the value of its assets had evaporated.

How could this possibly have happened? State law requires that all short-term state funds be invested in secure instruments. The definition of secure is that it must have the top AAA credit rating. In fact many mortgage derivatives carried that coveted AAA rating because until the real estate market began declining the bond rating agencies considered a mortgage on a home as good as a golden guarantee of the repayment of a debt. It was only once real estate prices began to decline earlier this year that this guarantee was revealed to be worth less than the paper it was written on.

State Treasurer David Lamoine is pointing blame for the bad investment to the broker at Merrill Lynch who sold the state the bad investment. There certainly might be some culpability on the part of the investment firm that recommended a flawed investment that would have been unsuitable for an individual investor. There is also reason to question Merrill Lynch’s recommendation of loans to a hedge fund that was co-founded by a former Merrill executive.

However, Merrill may not have done anything wrong according to securities regulations because the customer who bought the investment wasn’t an individual. The state is an institutional investor, which is expected to have experienced and competent financial professionals directing its operations. Perhaps Merrill Lynch should be punished for advertising a risky hedge fund as a secure AAA investment, but the state treasurer should have known that this was a risky and unsuitable investment for short-term money.

An institutional investor is not only expected to read the prospectus and ask the advice of its broker (who is really just a salesperson, not an advisor). The state treasurer should have been more prudent and should have used his knowledge and experience in the financial markets to have perceived that this was not a suitable recommendation for funds that belonged in something like a 30-day bank certificate of deposit.

Lamoine insists the state is going to recuperate its lost taxpayer funds. That is doubtful and that claim alone further calls into question his experience and knowledge of the financial market. Because the underlying security for the loan is in sub-prime mortgage bonds that currently sell at about 30 cents on the dollar, the investment will probably be only partially recovered and the taxpayers will be stuck with the loss.

I can’t blame Lamoine because he was trained as a lawyer and had no experience in banking and finance when he was appointed state treasurer. Lamoine got his job as a reward for his service as a Democratic Party operative. In Maine, constitutional officers are appointed by the majority party in the Legislature, not by election or by merit.

Now it is the responsibility of the Legislature to solve the problem. The state treasurer might have been misled, but he made a grave and costly error. For the sake of the people of Maine he should resign and the Legislature should appoint a bipartisan committee to seek applicants for the position and recommend a replacement based on knowledge, experience and background. Meanwhile, short-term state investments should be limited to treasury bills, CDs and similarly safe short term obligations.

R. Kenneth Lindell is certified financial planner in Belfast and former state representative where he served on the Insurance and Financial Services Committee.