On January 4, 2008, Vikas Bajaj of the New York Times reported that the State Street Corporation ? the manager of $2 trillion for pension funds and other institutions ? had ousted a senior executive and set aside $618 million to cover five legal claims filed by clients for losses related to mortgage?backed securities. The five clients sued over losses of tens of millions of dollars invested in State Street funds that were supposed to hold risk-free debt such as U.S. Treasuries. One of the funds lost 28% of its value over the summer after it placed big bets on mortgage?related securities.
According to the report, four of the lawsuits were brought by pension fund clients ? Prudential Retirement Insurance and Annuity Company, and pension funds at Nashua Corporation, a New Hampshire manufacturing firm, Unisytems, a publisher, and Andover Companies, an insurance company. It is unclear who brought the fifth suit.
The Prudential suit alleges that its clients ? 165 retirement plans covering 28,000 people ? lost $80 million by investing in State Street funds. According to the suit, State Street borrowed money to invest in subprime mortgages and related derivative contracts in a fund that was supposedly limited to investing only in Treasuries and corporate bonds, and, when Prudential sought more information about the investments, it received evasive and incomplete answers. The complaint alleges that one State Street executive told Prudential that its strategy had changed and it “forgot there was a lot more risk in the strategy.” State Street declined to discuss the allegations of any of these lawsuits for the article.
State Street thus joins other financial firms around the world that have been sued or investigated because of subprime mortgage investments ? a list that includes Bear Stearns, Morgan Keegan, an Australian unit of Lehman Brothers, and Terra Securities of Norway. This list is sure to grow in the coming months and even years.
Mr. Bajaj quoted a securities lawyer at a well-known Newark, New Jersey law firm about these suits against State Street. His comments seemed to imply that the lawyers for these clients were trying to pull a fast one in bringing suit under the Employment Retirement Income Security Act of 1974 (ERISA) for State Street’s breach of its fiduciary duty to pensioners rather than for securities fraud. (“The plaintiffs’ bar is very clever . . .. They are looking at ERISA as a way to get out of fraud pleading requirements.”) In fact, ERISA was passed to protect employees’ pension benefits, and its use in these lawsuits is entirely proper. Is there some requirement that pension plan participants not avail themselves of the very statute that was passed to protect them?
This securities lawyer then predicted that defendants in such subprime lawsuits would argue that investors made money from these investments for a time and knew or should have known that the risk existed that they could lose money and that the bonds in question were highly rated by credit ratings agencies. These arguments are totally contradictory. Investors ? especially pension funds ? invest in highly rated fixed income securities precisely because the ratings indicate a high degree of safety and a lower degree of risk. Pension funds and other savvy investors know that there is always some risk in every investment. It makes no sense, however, to say that the pension funds invested in securities because they were highly rated, i.e., safe, but that they should have known that such securities were extremely risky and could have lost substantial sums of money.
This whole subprime debacle will, at least for the short term, expose several structural deficiencies in the way that Wall Street creates and markets these artificial investment products. The next few months should be interesting.