Ruing CDOs Down Under Australian Beach Suburb Discovers Its Exposure To U.S. Subprime Woes

Ruing CDOs Down Under Australian Beach Suburb Discovers Its Exposure To U.S. Subprime Woes
WSJ, 4-Oct-2007
By JACKIE RANGE

At a recent meeting of the Manly Council, which governs a beachfront Sydney suburb, topics included Meals on Wheels, an antismoking policy for outdoor areas and U.S. subprime mortgages.

Earlier this year, the council handed 5.5 million Australian dollars (US$4.9 million) to Grange Securities, a small Australian investment bank. Council staffers were taken with the idea of slightly higher returns that Grange representatives proffered. They also were put at ease by Grange's client list, which includes dozens of Australian councils.

Grange was "quite firm and quite positive about the fact that they thought they could do a bit better than what we were doing ourselves," says Jenny Nascimento, manager of finance operations at Manly Council.

Now, Manly is ruing its investment decision, as are many councils across Australia. Manly officials say A$3 million of the money the council gave Grange was invested in collateralized debt obligations -- bonds underpinned by large pools of debt, including, in one case, U.S. subprime mortgages. As of Aug. 31, Manly was facing a paper loss of A$588,767 on the money it gave to Grange, funds that were collected from residential and business taxes, and charges for sporting facilities and parking, among other things.

"All of the client base are recognized as sophisticated investors who are responsible for their own due diligence relating to their investment decisions," a Grange spokesman said. "However, we do spend a great deal of time explaining the investments to our clients and ensuring all risks, etc., are clearly outlined in the documentation."

Initially, CDOs and other mortgage-backed securities were almost solely in the purview of investment banks and hedge funds. As these sophisticated buyers became saturated and the U.S. housing boom of the past several years kept delivering vast quantities of mortgages, the banks that created CDOs and other mortgage securities looked further afield for potential buyers to sop up the supply. Last year, banks issued $388 billion of all types of CDOs world-wide, up from $52 billion in 1999, according to Dealogic, a data-research firm.

They found a willing audience among town councils, small governments, charities, conservative state-run banks and risk-averse individual investors. Most of them were outside the U.S. and many had just a few million dollars, at most, to invest.

CDOs were appealing to many of these average investors because they promised to add a dash of juice to their investment portfolios. Although CDOs often are portrayed as complex and risky derivatives that offer huge returns, in many cases they offer an interest rate just a smidgen above government securities or a savings account, but supposedly with no more risk.

SachsenLB, a conservative state-run bank in Germany, was so enamored with mortgage securities that it set up an operation to trade mortgage securities and handle other investments from an office in Dublin. Bank of China Ltd., a big state lender, said its exposure to U.S. subprime mortgages stood at $9.65 billion. In the U.S., by comparison, the take-up among conservative investors looks relatively small.

The CDOs that washed up on Manly's tree-lined beaches were selected by Grange, which has since been bought by Wall Street brokerage Lehman Brothers Holdings Inc. The firm distributed its first CDO in 2002. Grange negotiated with investment banks such as Lehman or Barclays PLC of the United Kingdom to tailor products for its conservative client base, people close to Lehman said. "We saw an opportunity and, indeed, a need from an investor base to get advisory services and have access to the broader fixed-income market," said Glenn Willis, Grange's country head.

By August 2005, there were A$5.7 billion of publicly offered Australian CDOs outstanding, according to an Australian central-bank report. Since 2002, roughly 65% of Australian CDOs were bought by such investors as local governments or charity endowments.

Manly is part upscale Sydney suburb and part beach town. Many of its residents enjoy one of the world's most stunning commutes, riding ferries across Sydney Harbor, past the famous Sydney Opera House, to get to work.

The town, which invested a sum equivalent to roughly 10% of its annual operating budget with Grange, now is counting its losses. Manly saw the value of its investment in one CDO called Federation plummet to A$172,310 as of Aug. 31, from its original investment value of A$500,000.

Many other Australian councils face the same predicament and must decide whether to suffer the losses now or hang onto securities that face an uncertain future. "We're good at local government, but we're not necessarily good at investment," said Ross Fleming, Manly's chief financial officer.

Three councils say Grange put them into CDOs that were outside their criteria for investments or contained other irregularities, according to people familiar with the matter. For instance, the CDO called Federation is due to mature in 2047, exceeding the 10-year limit for the Woollahra Council, another Sydney suburb, to hold any security.

Grange has paid at least several million dollars in reimbursements to councils, council officials say. They declined to comment on why the money had been paid, citing confidentiality agreements with Grange. Woollahra Council, for instance, demanded the Federation security be bought back, and Grange complied, said Tony Lewis, managing director of Lewis Securities Ltd., who acted as an independent adviser to the council.

Grange declined to comment on individual clients. A spokesman said that the firm has "canceled trades" in a limited number of instances and that it "engaged in appropriate selling practices in the distribution of its products to clients." People close to Lehman note that more than 90% of Grange's CDOs have performed well so far.

Another gripe was that some of its CDOs, which contained U.S. and European assets, had Australian names, such as Kalgoorlie (a western Australian mining town famous for gold, nickel and brothels).

These labels disguised the true nature of the investments, some say. "I will make the conclusion that they were trying to mislead us, by giving Australian names to U.S. assets; you can draw your own conclusion," said Councillor Andrew Petrie in Woollahra, which owned Kalgoorlie. "If they'd been called 'Detroit,' you'd have said, 'What's this?' "

The Grange spokesman said the securities were denominated in Australian dollars and had other Australian characteristics. Market participants said it wasn't unusual for such securities to have Australian names.