PI Original Progress Illinois Friday April 24th, 2009, 10:07am

A Closer Look At Those Bright Start Losses

Back in January, we learned that risky financial maneuvers by the Wall Street managers of Illinois' college savings program had led to a swift $85 million loss.  The Prairie State wasn't alone in this situation -- Oregon, Texas, Maine, and New Mexico also included ...

Back in January, we learned that risky financial maneuvers by the Wall Street managers of Illinois' college savings program had led to a swift $85 million loss.  The Prairie State wasn't alone in this situation -- Oregon, Texas, Maine, and New Mexico also included Oppenheimer's "Core Bond Fund" as an investment option for families saving for college and suffered steep losses as a result.  Illinois State Treasurer Alexi Giannoulias, who oversees the program, was the first state official to accuse Oppenheimer of investing outside of the fund guidelines and pursue legal action against them.  Others have since followed suit.

In the months since he entered litigation to recoup the $85 million, Giannoulias also launched an exploratory committee for next year's U.S. Senate race and announced raising over $1 million in his first month of fundraising.  The Illinois GOP is now attempting to capitalize on the Bright Start controversy, recently releasing a web ad that places the responsibility squarely on the state treasurer's shoulders.  The story will be an ongoing headache for Giannaoulias, no doubt.  But the claim that he absolutely should have known about the extreme risks taken by Oppenheimer is unsubstantiated at this point.

Here's what we know (bear with us on this one):

By the time Giannoulias took office in 2007, the Bright Start college savings plan had amassed 180,000 portfolios and nearly $2 billion in assets.  It had also been long-criticized for its high costs and limited investment options.  Intent on lowering those administrative costs, Giannoulias selected Oppenheimer to manage the portfolio through a competitive bid process that year. The investment bank suggested Illinois invest in a series of their mutual funds, including the Core Bond Fund, which was billed as one of the company's most conservative investment strategies. The treasurer's office contributed $200 million to this fund and immediately saw its fortunes rise.  By April of last year, Chicago-based investment rating group Morningstar had named Bright Start one of the top five college savings plans in the nation.

Unfortunately, things took a turn for the worse later in the year. It turned out that Oppenheimer's then-Senior Vice President of Fixed Income Angelo Manioudakis had decided to roll the dice with the fund.  He not only invested it in risky mortgage-backed securities, but -- worse yet -- heavily leveraged the fund.

Once the housing market seized up and Giannoulias's office realized what Manioudakis had done, they immediately transferred all Bright Start monies allocated to Core Bond to short-term U.S. treasury debt. But that wasn't before investors lost 36 percent of the $200 million originally committed to the fund. The following month, the state served subpoenas on Oppenheimer under the Consumer Fraud Act. “Core Plus’ performance is unacceptable," Giannoulias wrote in a statement earlier this year, "and even more staggering when you consider that families thought they were investing in relatively conservative portfolios as their children neared college age." Speaking on WLS’ Don Wade and Roma earlier this week, the treasurer said he is "optimistic" that the state will ultimately recoup the families' money. 

The lingering question is whether the extreme risks being taken by Oppenheimer were visible to Giannoulias -- as well as the broader community of investors and analysts -- and whether the treasurer should have been expected to act faster to protect Bright Start investors from the exposure.

In two recent posts on the subject, Crain's Greg Hinz has largely focused on whether the treasurer should have known that the fund was dabbling in mortgage-backed securities and derivatives. In his first blog entry, he points to the Core Bond prospectus:

Core Bond's prospectus says it will invest in domestic and foreign debt, domestic and foreign bonds and (italics added) "mortgage-related securities (including collateralized mortgage obligations)....The Fund can also use derivative instruments, including futures, swaps, CMOs."

In a subsequent post, Hinz reiterates that the prospectus included warning signs:

Those sophisticated enough to read the prospectus on the mutual fund on which Core Plus was based got much more detail on what could go wrong.

But here's the catch: While Oppenheimer might have disclosed the fact that it was investing in these particular types of instruments, even the Morningstar analysts in charge of keeping tabs on this fund weren't aware of the degree of leverage being employed. Check out these comments in January from Eric Jacobson, who monitored Core Bond for Morningstar:

Jacobson ties the [Core Bond] losses to leverage used by fund managers. The fund had huge exposure to not only mortgage-backed securities, but credit default swaps. In effect, they had investment exposure equivalent to 180 percent of their assets. And when those markets collapsed at the end of September, the bad investment choices were compounded by the leverage, leading to outsized losses.

Morningstar said it couldn't find any disclosures in the funds' legal documents allowing them to use this kind of leverage. And "it was never brought up by the managers in their Morningstar interviews," said Jacobson in his report.

"It comes awfully close to dishonesty by omission," Jacobson said.

Another Morningstar analyst, Greg Brown, said the following to Bloomberg this week:

Greg Brown, an analyst at research firm Morningstar Inc. in Chicago, said the fund’s risk profile “changed rather quickly and due to the delay in regulatory filings, it was difficult to stay on top of the fund -- especially when Oppenheimer did not adequately disclose the risks and leverage they were using.”

Again, the degree of leverage is key. In his first post on the controversy, Hinz quoted Brown making a similar point:

"I have to think there's more blame on Opppenheimer than the state (of Illinois) in not providing more information," he adds. "Core Bond was almost run like a hedge fund...a lot of leverage."

Brown then went on to say that more questions from the treasurer's office might have led to earlier action:

"Had the state asked for more information, they may have eventually figured out how much risk there was," Mr. Brown says.

The same goes for Morningstar, of course.

While Giannoulias' office has declined to give any details about the ongoing litigation, the lawsuit recently filed against Oppenheimer by Oregon state officials is based on the charge that the fund "exceeded its risk controls":

The Core Bond Fund investment managers ignored the warnings of OppenheimerFunds' own risk managers when the fund exceeded its risk controls in April 2008, the complaint says. Instead, fund managers decided they would continue to place "big bets" with the college savings plan and other investors' money.

The "risk controls" are also at the center of a class-action lawsuit on behalf of individual Core Bond investors.

Once litigation concludes, we'll find out how this issue factors into Illinois' complaint.  Furthermore, Giannoulias will be able to respond directly to allegations that he wasn't diligent enough in monitoring this fund.

In the meantime, let's remember that independent analysts also missed what was happening at Oppenheimer and that Giannoulias was, in fact, the first state official to catch on.  Finally, it should be noted that Morningstar is still recommending the Bright Start plan:

All told, the plan still holds plenty of appeal; its untainted "Index Portfolios" are still the cheapest nationally available Vanguard options.


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