The deal is still tentative, but it looks like families who suffered considerable losses last year via Illinois' Bright Start college savings program may be in for some good news.

At the beginning of the year, we learned that risky, hidden trades by Oppenheimer Funds, Bright Start's Wall Street manager, had led to $85 million in losses in the so-called Core Bond fund. (For the backstory, read our post from April.)  While several other state college savings programs also had exposure to Core Bond, Illinois Treasurer Alexi Giannoulias was the first to react to the problems.  Along with Attorney General Lisa Madigan, he began negotating with Oppenheimer in January, telling investors, "We want to hold this fund manager responsible for this reckless investment strategy."  Almost five months later, the Treasurer's office has confirmed that Illinois recently reached a "handshake deal" that would return $77 million to the affected Bright Start accounts:

Now, after months of negotiations with Oppenheimer, the fund management company, the state has a tentative agreement to recover $77 million for fund investors -- which would be a remarkably high recovery for a negotiated settlement. The amount that will be returned to each affected account will depend on a complicated formula that is still being negotiated.

Back in April, Giannoulias faced a lot of heat about his oversight of Bright Start, first from Crain's columnist Greg Hinz and then from Illinois Republicans.  The controversy only grew as he refused to comment about the deal, citing the ongoing negotiations. 

Specifically, critics raised questions about whether Giannoulias should have been aware of the extreme risks taken by Oppenheimer. Some further suggested that the Treasurer had failed to act quickly enough to protect Bright Start investors from the exposure. Both claims are legitimate enough; while Core Bond rebounded in the early summer (after Giannoulias emailed Oppenheimer expressing concerns about its performance) and dropped significantly in September (like many funds were doing at that time), it fell off a cliff in October and November, two months before Giannoulias stopped the flow of new money into the fund.

But as we noted at the time, much of the coverage glossed over the issue of leverage. While Oppenheimer did disclose its investments in mortgage-backed securities, the Morningstar analysts in charge of keeping tabs on Core Bond expressed surprise at the degree of leverage being employed, largely through $1.4 billion worth of "swaps." A Morningstar article from April explains more about Oppenheimer's use of these instruments: 

At the end of March 2008, the Core portfolio carried around $400 million in securities exceeding its then $2.2 billion in net assets via transactions that were effectively akin to margin borrowing. It also had roughly $800 million in long exposure to corporate credit via default swaps -- including American International Group AIG, Lehman Brothers, Wachovia WB, Washington Mutual, and Bear Stearns. It had around $600 million in total return swap exposure to a volatile slice of Barclays' AAA rated CMBS index. By normal reporting convention, all of these positions were not included on the fund's balance sheet and, thus, not in its net assets.

By the end of September, when the market sailed off into uncharted territory, Core Bond's credit exposure to those markets totaled more than 180% of net assets on a dollar basis. In other words, for every dollar of shareholder capital in the fund, it was exposed to the credit-driven movement of more than $1.80 worth of securities.

The message here isn't that derivatives are bad, though they can be dangerous if not well understood. Rather, it is that investors had little way of knowing that the funds were piling high extra layers of market exposure. Because most of this additional market exposure came from off-balance-sheet derivatives, the funds' portfolios didn't look highly leveraged. In a conventional accounting sense of leverage -- borrowing money against net assets and investing it -- they might have looked slightly leveraged. But in a economic sense, and as a mutual funds go, they were heavily leveraged.

In an email to the Oregonian's Brent Hunsberger last month, Morningstar's Miriam Sjoblom cited the total return swaps as the "chief culprit":

[T]he economic leverage created by the commercial-mortgage bond total return swaps was the chief culprit in the magnitude of the fund's losses last year.

It seems probable that the swaps -- which may have been kept off the fund's balance sheets -- will form the basis for any settlement.

That being said, Giannoulias emphasized that nothing is final yet. Indeed, one family that invested in Bright Start filed an arbitration claim against Oppenheimer late last week, which could throw a wrench in the settlement. But with any luck, most of the money could be retrieved shortly.