Democratic U.S. Senate nominee Alexi Giannoulias is getting reamed for his stewardship of Illinois' 529 college savings program. How much blame does he really shoulder?
Bright Start, Illinois' 529 college savings program, has become a hot-button campaign issue this fall. U.S. Senate nominee Alexi Giannoulias is getting dogged by both U.S. Rep. Mark Kirk's campaign and outside groups for his stewardship of the program, which lost $150 million in value during the nadir of the national economic crash. GOP State Treasurer nominee Dan Rutherford is also using Bright Start to bludgeon Democratic nominee Robin Kelly, who worked in Giannoulias' office when Bright Start declined in value. Here's one example of a campaign ad on the topic, paid for by Karl Rove's Crossroads Grassroots Policy Strategies:
While the headlines are damning for Giannoulias, the story of Bright Start's troubles is far more complicated than these ads let on. In a front-page story yesterday, the Tribune tried to get to the bottom of the controversy, gathering documents and e-mails under the state's open records law to determine whether Giannoulias took enough steps to protect families who had invested their hard-earned money with the state.
The paper's two reporters certainly move the ball forward, providing never-before-read context about how Giannoulias' office dealt with Oppenheimer Funds, the investment firm that was in charge of the state's 529 portfolio at the time. But even their piece glosses over one critical component of the story, one that largely (but not entirely) absolves the Senate candidate and his colleagues from blame. Here's a review of the situation.
(One definitional note: in emails obtained by the Tribune and in a statement Giannoulias made in 2009, Core Bond is referred to as Core Plus. They mean the same thing.)
The Core Bond Fund
The controversy over Bright Start stems from the performance of a particular mutual fund (Core Bond) managed by Oppenheimer's former Senior Vice President of Fixed Income Angelo Manioudakis. Here's a brief introduction from a post we wrote last year:
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.
Those mutual funds, however, were filled with risky (and now infamous) mortgage-backed securities. That became problematic when the housing market seized up in the summer of 2008. Following the collapse of Bear Stearns, Core Bond began to dip in value. According to the Tribune's report, Shirley Yang -- the treasurer's director of college savings programs -- sent an email to Oppenheimer on May 6 asking them to attend a meeting with her boss later that month. That pow wow took place on May 19. A few days after, Yang sent the investment firm a follow-up email that "specifically noted concerns about Core Plus and asked Oppenheimer to explore how other college savings plans were using such fixed-income funds," the Tribune reported.
The market didn't improve in June or July of 2008. By August, Yang's questions became more pointed. "I think the bottom line is we're having a difficult time answering the question of 'why should we stick with Core Plus?'" she wrote. Losses quickened in the fall and the office grew increasingly nervous. Giannoulias sought advice from both Oppenheimer and an outside consultant, who suggested he give Core Bond some additional time to recover. He proceeded to send a letter to account holders on October 29, suggesting that the losses would dissipate "when credit markets normalize."
That, of course, never happened. Late that fall, staffers from the treasurer's office met once more with Oppenheimer, according to the Tribune's records. "In November we hit the low point," Yang said in an interview with the paper this week. "We said we'd had enough. [Giannoulias] basically said, 'We're done.'"
In early December, the Democrat immediately transferred all Bright Start monies allocated to Core Bond to short-term U.S. treasury debt. While almost every other fund of this type declined in value in 2008 (usually in the range of 7 to 8 percent), Core Bond ultimately took a much larger hit (36 percent), amounting to about $150 million in losses.
The following month, the state served subpoenas on Oppenheimer under the Consumer Fraud Act. "Core Plus’ performance is unacceptable," Giannoulias wrote in a statement in early 2009, "and even more staggering when you consider that families thought they were investing in relatively conservative portfolios as their children neared college age." He then joined forces with Attorney General Lisa Madigan, eventually reaching a deal to recoup $77.25 million of the state's losses.
After looking at the entire timeline, the Tribune's reporters came to this conclusion:
Documents and e-mails recently obtained by the Tribune under the state's open records law show the rookie treasurer and his staff were concerned early on about the aggressive move by OppenheimerFunds Inc. in what was supposed to be a more conservative fund in the Bright Start program.
But at each turn Giannoulias stuck with the firm's strategy, even as the housing market soured and losses accelerated.
That's a fair assessment, to a point. It's true that Giannoulias probably waited a few months too long to pull the families' assets out of Core Bond, a point we've criticized him for in the past.
Still, the Tribune makes a giant error of omission in its story that deserves serious scrutiny.
Hidden Default Swaps
Way down in the fourth-to-last paragraph, the paper paraphrases a quote from Giannoulias about Oppenheimer's investment strategy. "Losses were made worse," they write, "because the fund was invested in even riskier credit-default swaps, which [Gianoulias] said was hidden from his office." Strangely, the reporters don't tug at this thread that at all. And it's the most important component to the whole saga.
While Oppenheimer disclosed to the state that it was investing Core Bond funds in mortgage-backed securities, the Wall Street managers also dabbled in "off-balance-sheet" transactions, which often involve derivatives such as swaps and allow investment managers to take on extreme market exposure while literally hiding it from their clients. In other words, the mutual fund was severely leveraged and only Oppenheimer staffers knew about it. A Morningstar article from April 2009 explains more about the firm's secretive 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.
What does this mean in practical terms? When the markets dipped, Core Bond's value sank like an anchor. In an email to the Oregonian's Brent Hunsberger, another analyst at Morningstar cited the total return swaps as the "chief culprit" in the "magnitude" of the funds losses. So did Madigan in her statement following the settlement. And because those investments were kept out of sight from the treasurer's office, Giannoulias had no way of analyzing the risk. "It was almost impossible," the AP concluded in its "fact check" last year, having talked to several financial experts, "to sort out the overall problems from mismanagement in particular funds."
At one time, Kirk understood this. When asked by a reporter who was to blame for the Bright Start calamity, the Republican points to Manioudakis, the fund manager who was eventually dismissed. Watch:
With the campaign entering the home stretch, though, Kirk has tweaked his answer, choosing instead to whack Giannoulias in an ad for "misleading" families about their college investments. It's an easy political hit because the losses were so large and the investment instruments so opaque. But Oppenheimer is the true villain of this story, not the treasurer's office.