How to Energize Your Cash

Before we get to the How-To's let's first take a look at what's happening on State Street. The Houston Chronicle is reporting State Street Stock Falls on Credit Woes.

State Street Corp. has nearly $29 billion in exposure to a type of investment that has recently contributed to turmoil in world financial markets, according to a regulatory filing by the Boston-based trust bank.

An Aug. 3 quarterly filing with the Securities and Exchange Commission puts State Street's holdings in an investment known as asset-backed commercial paper conduits at $28.81 billion as of June 30, up from $25.25 billion at the end of last year

The State Street Limited Duration Bond Fund, which includes investments in mortgage debt, fell about 37 percent in a three-week period, the Globe said, citing an investor who received a client letter from State Street about the loss.

In Further fiasco, the Boston Globe is also writing about State Street.

The State Street Limited Duration Bond Fund, which managed $1.4 billion for institutional clients, lost about 37 percent of its value during the first three weeks of August, according to the investor. The fund, managed by State Street Global Advisors, had fallen 42 percent for the year by Aug. 21, the investor said.

The possible cause of the fund's big losses: investments in mortgage-related securities, and leverage that magnified the problems. Flannery's letter describes a fund that "increasingly focused on housing-related assets." Meanwhile, the fund borrowed to increase its portfolio to between two and three times the amount of money clients had given State Street to invest, according to one investor.

The State Street Limited Duration Bond Fund was created in 2002 as a way to generate better results than those of money-market funds with only slightly more risk. The fund was widely considered an "enhanced cash" product, an investment category usually considered very low risk. It was sold only to institutional clients, not individual investors.

Some of the State Street fund's investments may bounce back, given enough time. The real question is how State Street got their clients in this hole in the first place.

State Street Corp (STT) Weekly Trendline



(click on chart for a sharper image)
The weekly trendline on State Street is now busted no matter how one draws it.

Some inquiring minds might now be tired of hearing about State Street and wondering "How does one energize cash?"

How to Energize Cash

The formula for energizing cash is actually rather easy as Michael O'Hara explains:

1. Maintain Liquidity
2. Maximize Yield
3. Control Risk

Strategies can be "designed to provide investors with the liquidity that they require to earn incremental yield over core cash funds, and to employ a disciplined investment process that controls downside risk."

That answer just might spawn two additional questions:

1. Who is Michael O'Hara?
2. Exactly how does one execute that strategy?

The answer to those questions can be found in Energizing Your Cash.

Hi, my name is Mike O'Hara. I'm the portfolio manager for SSgA's [State Street's] Limited Duration Bond Strategy. We designed the Limited Duration Bond Strategy to maximize yield while controlling volatility. The Strategy's objective is to outperform 3 month LIBOR by 50 basis points over a one-year period.

Portfolio Composition

To maintain liquidity, approximately one third of the Strategy is invested in AAA and AA rated securities. To enhance yield, about another third of the portfolio invests in A and BBB rated structured products. The remainder of the portfolio takes advantage of SSgA's expertise in swaps and other derivatives to generate arbitrage opportunities. To respond to immediate liquidity needs, a small portion of the Strategy is invested in overnight funds.

The State Street Model

Here is a chart depicting the State Street Investment Model



At this juncture, inquiring minds might be interested to learn more about AAA vs. BBB Bond Ratings as referenced in the above chart.

Facts in hand, we now have the answer to the question posed by the Boston Globe: "The real question is how State Street got their clients in this hole in the first place." The graphical answer appears above. A textual answer to the question is by chasing yield, ignoring risk, and doing so with leverage while proclaiming "expertise in swaps and other derivatives".

Comparison of Strategies

PIMCO had a strategy of buying long duration AAA rated paper (Please see Bill Gross Wants PIMCO Bailout and A Gross Challenge for additional information) while the latter had a strategy of buying short duration paper next to pure junk. State Street's strategy has clearly blown sky high.

Let's assume (I do not have actual figures in hand) that State Street met its goal as follows: "The Strategy's objective is to outperform 3 month LIBOR by 50 basis points over a one-year period."

On second thought let's assume State Street exceeded their performance goal by 50%. With that in mind, here are the adjusted returns vs. 3 month libor (not compounded but including 50% outperformance vs. stated strategy) since 2003.

2004: +00.75%
2005: +00.75%
2006: +00.75%
2007: -37.00%

That folks is the folly of chasing minuscule returns over treasuries. Lawsuits are likely to fly over this.

And just to be sure that I had the correct Limited Duration Bond Fund (there are many funds with that name) I gave State Street a call yesterday. The operator confirmed that Michael O'Hara was an employee of State Street in the fixed income department. O'Hara was not available at the time I placed the call.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/