Wildfires in the mortgage-backed derivatives market have burned some municipal issuers recently, but investors aren't hitting the panic button.
Municipalities in Ohio, Texas, Florida, and Maryland suffered big losses over the past year after investing in mortgage-backed derivatives to boost the yield on their investments.
The latest victim is the Odessa Junior College District in Texas, Standard & Poor's Corp. downgraded the district's bonds on Friday after discovering that the district's investment portfolio, composed entirely of mortgage instruments, had dropped 50% in value.
With little or no warning, bond investors often find themselves stung by such losses and the subsequent decline in an issuer's creditworthiness.
Some investors are confident that the problems are few and far between. Others are calling for more disclosure by issuers to keep investors abreast of any problems.
"If you've taken a 25% or 30% hit, that's material and it should be disclosed," said Tom Kenny, head of municipal research at the Franklin Funds. "Right now, issuers don't have to."
Without better disclosure, investors are vulnerable, Kenny said.
"My general feeling is that quite a few of these stories have not yet been told," he said. "We've seen the problems with derivatives on the corporate side, but because of the lack of disclosure, I think there are probably some municipal problems that haven't come out yet."
Holding a diverse portfolio of bonds tends to cushion the impact of unexpected problems cropping up with one or two credits, some investors said.
"The fact is, you're dealing with thousands of issuers, and most of them do take their responsibility for conservative investment practices seriously," said Joseph Rosenblum, director of municipal credit research at Sanford C. Bernstein & Co. "Diversity is probably your primary defense against these events when they happen."
Rosenblum added that issuers have gotten into trouble with bad investments in the past. "This happens in cycles -- this is not the first time," he said. And the damage is usually limited to "only a handful during each cycle," he said.
A portfolio manager at another firm referred to the losses as "bolts from the blue." In some of the recent cases, an individual has put an issuer's funds in mortgage derivatives contrary to the issuer's investment guidelines.
"We do our homework, but we cannot anticipate a treasurer ignoring his investment guidelines and buying something that is not a permitted investment," the manager said.
Another manager pointed out that most issuers use derivatives conservatively. "In most cases, issuers are using derivatives as a hedge to lower borrowing costs," the manager said. "Investing in derivatives is a speculative usage we haven't seen much of."
Mortgage-backed derivatives are among the most volatile and unpredictable investments. The securities are based on pools of home mortgages, often backed by the Federal National Mortgage Association. As homeowners repay the principal and interest on the underlying mortgages, the payments are passed through to the derivative holders.
The government backing nearly eliminates credit risk and gives the securities a triple-A rating.
But the greater risk is that the securities' market value may fluctuate unexpectedly. Homeowners can repay principal or even refinance a mortgage ahead of schedule. Unscheduled payments can wreak havoc on the derivative securities, causing their value to rise or fall dramatically.
Some investors are more worried. Portfolio diversity provides some protection, but "all these problems may not be minimal," Franklin's Kenny said. "Someone could really get killed."
And the problems can be more acute for managers of single-state funds. To provide double- or triple-tax-free income, the single state funds limit their purchases to issuers within the state and Puerto Rico. Interest on Puerto Rico issues is exempt from taxation in all 50 states.
One Maryland fund manager said he was concerned about the recent problems of Charles County, Md. The county's former deputy treasurer illegally invested all of the county's portfolio -- $30 million --in mortgage-backed derivatives, county officials admitted earlier this month.
Although the manager did not own any Charles County bonds, "that could have been a big problem for me. I can't go outside the state, and an issue like that could make up 4% or 5% of my portfolio."
The rating agencies provide a primary line of defense, market participants said. Surveillance analysts review rated credits at least once a year at Standard & Poor's, for example.
"Instances like Odessa have become more commonplace in the past few years," said Steve Gortler, associate director in the rating agency's surveillance group. "So we are making more of an effort to be proactive, to inquire about investments and pay more attention to where issuers have their funds."
Most investors also review bond offering documents. "We look at the permitted investments, and we don't like to see anything exotic there," one portfolio manager said.
Insurance also mitigates the damage. While $78 million of Charles County, Md., bonds were downgraded due to derivatives losses, another $31 million were not because they carry insurance from AMBAC Indemnity Corp. and Financial Guaranty Insurance Co.
And the losses don't always have a substantial credit impact. In some cases, the firms that sold the derivatives to the municipalities have offered to make full or partial restitution.
That's because courts have allowed municipalities to void illegal transactions in some cases. If the derivatives were not a "permitted investment," a court might order a firm to pay back the issuer's entire principal.