Faith In System Erodes Brick By Brick

Bloomberg is reporting SEC to Rework Rules After Funds Struggled With Subprime Prices.

The U.S. Securities and Exchange Commission is updating rules for how mutual funds value holdings after they struggled to price mortgage-backed investments during the subprime-lending crisis.

"Funds seem to be relying on stale pricing on several occasions," Scheidt said in an interview today. "They were continuing to value the securities at prior levels" even though "facts would suggest that the price would have gone down."

The new rules, which will be binding for companies registered under the Investment Company Act, mark the agency's "first comprehensive" revision in four decades, Scheidt said.

When prices don't exist because an exchange is closed or an asset is infrequently traded, funds base valuations on prices for which they can reasonably expect to sell. In such cases, fund managers rely on quotes from brokers and pricing services.

Inaccurate asset prices may prompt mutual-fund managers to overestimate a fund's net value and overpay when shareholders sell back their stakes. That can shortchange long-term investors.

When demand for subprime-backed debt dried up last year, more than 80 percent of investment managers had difficulty obtaining prices for mortgage-related investments, according to a September survey by Greenwich Associates.

Brokers stopped providing quotes out of concern they might have to honor the prices and buy back securities that had plummeted in value, said Timothy Sangston, a managing director at Greenwich Associates, a financial-services consultant based in Greenwich, Connecticut.

To prevent investor losses, Baltimore-based Legg Mason has arranged $1.47 billion in financing for its money-market and cash funds since November. In December, Atlanta-based SunTrust injected $1.4 billion into two money funds, and Bank of America, the second-largest U.S. bank, said it would wind down a $12 billion cash fund. Cash funds, which are sold to institutions and wealthy individuals, offer higher yields by investing in riskier assets.

Within the $12.1 trillion U.S. mutual-fund industry, the biggest subprime-debt investors are taxable bond and money-market funds, which managed a combined $3.93 trillion of assets as of November, according to the Investment Company Institute.

In November GE's "enhanced" cash fund broke the buck. GE was an institutional money fund not a retail money market operation, and it is now closed.

In December, Bank of America shut its $12 billion cash fund.

The so-called enhanced-cash fund, which was only offered privately to institutional investors, saw its net asset value dip below $1 recently. Big investors that want to redeem are being paid "in kind," which means they get their share of the fund's assets put into a separately managed account, according to Jon Goldstein, a spokesman for Bank of America.

"It's in the best interests of the fund and investors to start unwinding," Goldstein said. "Unprecedented conditions in short-term debt markets have weakened the performance of private cash funds like this one."

Such disruptions have sparked concerns that money-market funds could drop into negative territory. These types of funds are supposed to return investors' principal -- so if they "break the buck," as it's called, that would be bad news.

However, the $12 billion Columbia fund that's shutting down is not a money-market fund, according to Goldstein. As an enhanced-cash fund, it was supposed to take more risk to generate higher returns.

More Cash Injections Needed

Not wanting to break the buck further, Bank of America decided to hand over securities to any pension plan or large investor and essentially said "It's your problem now". That cannot be too inspiring for future business relationships. One of the results of what has transpired so far is bound to be reduced trust in institutions peddling all kinds of products.

These new rules all but insure more cash infusions will be required by institutional money funds and other funds that still have not marked assets to market. Etrade was caught holding client cash in illadvised debt instruments, and it may yet result in bankruptcy.

Douglass National Bank, Kansas City, MO Goes Under

The Kansas City Star is reporting, Douglass National Bank Fails.

The bank's failure is the first in the nation this year and the first in the area since Superior National Bank failed in April 1994.

Douglass has struggled with mounting loan problems and operated under March 2006 orders from regulators to improve its dwindling capital strength. In the last two years, losses had reached $5.6 million, and more than 20 percent of the bank's remaining loans were still considered problems as of the end of December.

The Office of the Comptroller of the Currency, which regulates nationally chartered banks, closed Douglass after its regular business hours Friday and appointed the Federal Deposit Insurance Corp. to be receiver. The FDIC said it sold $55.7 million of Douglass' assets to Liberty Bank and Trust at book value, less a discount of $6.1 million.

Depositors' accounts transferred automatically to Liberty Bank and Trust. The FDIC said customers could access their money this weekend by writing checks and using debit or automated teller cards.

Faith in the system is slowly but surely eroding, brick by brick. Failing banks will add to the worry. Investors have every right to be wondering "What's Next?"

I am expecting many more bank failures coming up. This is a warning call to anyone over the FDIC limit at any bank anywhere.

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