Bruce R. Bent, founder and chairman of the New York-based cash management firm The Reserve, is in a spot of bother.
The 71-year-old American, credited with having invented the money market fund back in the 1970s, has finally started paying back investors in his Reserve Primary Fund, from which there were billions of dollars of panic withdrawals in the immediate aftermath of the Lehman Brothers collapse on 14 September. And, at most, the investors are getting half their money back.
Reserve Primary was a big buyer of holdings in credit arbitrage funds or “conduits”. During the credit bubble years such funds were fashionable.
These are complex and opaque vehicles created by banks, which gave them deliberately obscure names. In addition to profiting from borrowing short on the commercial-paper market and investing long in opaque credit derivatives such as collateralised debt obligations, the funds had the advantage of enabling banks to park loads of dodgy credit issuance off balance sheet.
The ruse made it possible for banks to lend more without any concomitant need to increase the risk-weighted assets on their balance sheets (which they would otherwise have needed to do by regulators under Basel II regulations).
Before the credit bubble burst, regulators turned a blind eye to such chicaneries. After all, securitisation and the use of structured finance vehicles enabled the banks to reduce their risk, didn’t it? Former Fed governor Alan Greenspan and Bank of England governor Mervyn King believed it, so it had to be true!
While they could, investors including Bent were happy to milk conduits for all they were worth. The vehicles offered juicy yields at what seemed like low risk. Bent and his ilk didn’t mind that conduits were backed by risky assets such as impossible to fathom bundles of mortgages, car loans and credit card receivables. The credit ratings agencies including Standard & Poor’s and Moody’s had been only too happy to slap “AAA” ratings on them.
Bank of Scotland was already dabbling in residential mortgage-backed securities (RMBS) before its September 2001 merger with Halifax, having launched Mound Financing in 2000, apparently with a view to boosting its lending power without having to bother with increasing customer deposits.
The RMBS floating notes were given a AAA rating by Standard & Poor’s, which said “this is the first UK residential mortgage-backed transaction to use a both a receivables trust structure and, additionally, to include classes of notes with legal maturities prior to the maturity of all the underlying mortgage loans.”
Driven by the urge to increase its share of UK mortgage lending, Halifax Bank of Scotland went hell for leather into the securitisation market following the two banks’ merger. In the summer of 2002, Bank of Scotland launched Grampian Funding, a €40 billion vehicle ostensibly owned by a Jersey-based charitable trust. Halifax followed suit by launching Permanent Financing a few months later.
With the housing market in overdrive, HBOS as a group became a gung-ho player in the securitisation markets. The merged bank issued an astonishing £13bn of RMBS in 2003 through Permanent Financing, Mound Financing and its covered bond programme, just under half the total value of RMBS issued in the UK in 2003.
Grampian was latterly offering investors such as Bent coupons ranging from 5.04% to 5.5%. However Grampian was a much riskier bet than it seemed. Last year Grampian had $36.9 billion worth of asset-backed securities, including Alt-A residential mortgages (otherwise known as ‘liar loans’), on its books.
There was no mention of the Jersey-registered conduit in HBOS’s 2006 annual report and accounts. Yet the bank is now bizarrely claiming that Grampian Funding has always been fully consolidated into its balance sheet.
The vehicle first entered the limelight in August 2007, when HBOS had to step in to fund the $36 billion it owed and take the prevously “self-funding” conduit back onto its balance sheet. Just over a year later, however, the game was effectively up for HBOS.
After the wholesale markets froze in the wake of the bankruptcy of Lehman Brothers on 15 September 2008, HBOS’s share price fell like a stone, in a way traders say was unprecedented for a “blue chip” FTSE-100 company.
This was largely because investors — both wholesale funders and institutional investors in the bank’s equity — had realised that the bank had allowed itself to become so dependent on wholesale funding, which had dried up completely last September, that it had little or no chance of surviving as an independent concern.
It was also because it was well known in the City that the bank’s head of corporate lending Peter Cummings had a penchant for lending money to questionable entrepreneurs without asking too many questions.
Later that week the bank’s board effectively threw in the towel, recommending a government-assisted takeover by Lloyds TSB.
If this deal goes ahead, presumably one of the first things that the new management team, led by chief executive Eric Daniels, will be doing it taking a long, hard look at Grampian.
Bent’s Reserve Primary Fund was, until it “broke the buck”, the highest yielding of all the 2,100 money market funds tracked by Morningstar.
In addition to owning $1.1 billion of Grampian Funding’s paper, Reserve Primary also owned $785m of Lehman Brothers’ debt.
This blog was published on 2 November 2008