Breaking the Buck:

The Underlying Issues of the Sub-Prime

Crisis and Credit Crunch

Initially published October 22, 2008

Revised April 22, 2010

Prepared by:
David Justin Ross
Chief Investment Officer
Radiant Asset Management, LLC
dave@radiantasset.com
Breaking the Buck:
The Underlying Issues of the Sub-Prime Crisis and Credit Crunch

The Credit Crunch

The credit crunch that began with the sub-prime mortgage market has spread to funds that were

supposed to be safe places to keep short-term cash. Many short-term bond funds, ultra-short-term

bond funds, and money market funds have been adversely affected, some of them disastrously, by the

infection from the sub-prime melt-down. The current credit market problems have many causes but

three events converged into a perfect storm in late 2007 that not only worsened the crisis, but spread it

to other, supposedly safer credit vehicles.

1. The Sub-Prime Crisis – The market has discovered that packaging a collection of high-risk mortgages

into a Structured Investment Vehicle (SIV) does not make them any less risky. It just makes the

crunch worse when it comes. The incidents of default in these SIVs have been far worse than actual

defaults on mortgage payments, even in the sub-prime space. Many funds and banks that

purchased these SIVs attracted by their promised returns have been forced to liquidate their

holdings under duress, further deepening the crisis.

As housing prices fell and the credit crisis has deepened, sub-prime borrowers with adjustable rate

mortgages (or worse, with large balloon payments) found that much or all of the equity in their

houses had evaporated, making it impossible for them to refinance. When they defaulted, their

foreclosed houses glutted the market, causing other sellers to have to drop their prices. This led to

lower assessed valuations, helping to deepen the crisis and extend it beyond the sub-prime space.

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 While these defaults were only a relatively small (though much higher than normal) fraction of even

sub-prime mortgages, they had an outsized effect on the securities that were based on them.

2. FASB Rule 159 – This rule, promulgated in November, 2007, mandated, among other things, that

Level 2 and Level 3 securities be priced by their holders based on “observable inputs” if such were

available. Level 1 securities are continually “marked- to-market” (priced) and trade based on liquid

real prices. Level 2 are generally “marked-to-model” where there may be an observable input (such

as initial purchase price) but where there are no available quoted prices. Level 3 are valued on

“unobservable” inputs that reflect a company’s own assumptions about validation. In May, it was

Fannie Mae estimated that 23 percent of its entire holdings were in Level 3 assets1.

Companies purchased Level 2 and Level 3 securities based on their anticipated cash flow, and since

that cash flow was their primary interest, the ability to mark these securities to market was

considered unimportant. Not only was it difficult (or impossible) to do so, but evaluating these

securities based on a model (Level 2) or guesswork (Level 3) meant that their value didn’t change

very often – which produced a smooth NAV for the holding fund.

FASB 157 made it much harder for Level 2 (and some Level 3) holders to maintain the fiction of fixed

asset value. It requires them to price their holdings based on “observable inputs”, meaning

anything they could use to get a price closer to actual market demand.

Presciently, Paul Kedrosky2 said just before the rule came into effect, “[I]t's hard not to wonder if

FASB Rule 157, which comes into force this Thursday, will turn out to be the fire that lights the final

fuse here. While it's laudable and all to force transparency and push market pricing, when everyone

1
“Freddie Mac Accounting Cuts Losses by $2.6 Billion”, Bloomberg.com, May 14 2008.
2
“Credit Markets, Minsky Moments, and FASB Rule 157”, paul.kedrosky.com, November 13, 2007.

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 is forced to find a market price for illiquid instruments simultaneously during a credit crisis the

result is a regulation-imposed death-spiral, with devastating implications all around.”

3. “Observable Inputs” – The use of these for valuing securities were mandated by the FASB rule

changes of late 2007. Markit Group was among the first to introduce these for mortgage-backed

securities with their ABX derivatives indices. The ABX was launched in January 2007 to serve as a

benchmark for securities backed by mortgages issued to borrowers with weak credit and therefore

to provide visibility and transparency in the pricing of sub-prime-backed securities. In doing so, it

gave a way of estimating the value of these securities.

Figure 1 shows the relative value (in the

second half of 2007) of derivatives on BBB-

rated mortgage securities written in the

first half of 2007. BBB securities are the

top of the sub-prime category. It is worth

noting that the index starts at 100 when

Figure 1 – BBB-rated mortgage securities

the mortgages are written.

Since neither the mortgages themselves nor the SIVs traded often, there had no need for their

holders to attempt to determine their fair value for carrying on their books. Derivatives on the

mortgages, however, did trade3. These indices therefore offered a way of valuating the holdings

that met Rule 157 requirements. A vicious cycle resulted. Using the values of the indices, holders of

the SIVs were forced to downgrade the book value of their holdings. This, in turn, reduced the

demand for derivatives based on those SIVs, which further depressed the index.

3
Ibid.

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 To make matters worse, in August 2007, again in November, and yet again in early 2008, hedge

funds and banks were forced into massive asset liquidations. These assets included mortgage- and

asset-backed securities, CDOs (Collateralized Debt Obligations) and credit default swaps. This sale of

securities at distressed prices created more “observable inputs” in pricing – and further

deterioration in the indices. This, in turn, caused asset revaluation at all levels and ever greater risk

aversion across the credit markets.

Many of the SIVs have lost 90% or more of their value during this period. Since default rates in the

mortgages upon which they are based are nowhere near this extreme, the joke that the problem

here was that someone asked what these securities was actually worth contains more than an

element of truth. It does no good to force the sudden valuation of a security if that valuation leads

to panic selling of the security, destroying its value.

While some funds liquidated, others tried different approaches. Some, perhaps figuring that Level 3

securities were less likely to be forced into a pricing situation, restated much of their Level 2

holdings as Level 3. Others, in part out of fear that their own forced sales would create “observable

inputs” for other securities in their portfolios, delayed selling, only to find that in many cases the

market for their holdings had dried up entirely.

The situation was exacerbated when the distressed sales led to “events of default”. These were not,

in general, a default in the underlying security (though there were certainly some of those). Instead,

funds that were restricted to holding securities above a specified credit rating suddenly found their

holdings downgraded. They had to liquidate these holdings, further depressing prices and

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 swamping what few buyers remained. Many discovered the down side of ultra-short-term debt:

frequent rollovers are a problem in the absence of purchasers for those rollovers.

Funds that were negatively impacted as described above had been attracted to the securities by

their relatively high cash flow. They believed that by pooling the assets, default risk could be

minimized. Also by keeping them short-term, interest rate exposure could be minimized. As long as

the risks were borrower-specific – an issue here, a company there – this strategy worked. These

funds discovered however, that diversification evaporates in a crisis. As the credit crisis hit and

investments started to fall in value, investors rushed to withdraw their funds. To raise the necessary

cash, the funds were forced to sell already distressed assets into a market that was not interested in

buying them.

A recent Morningstar article stated, “The roots of [these] problems shouldn't come as a surprise to

readers. Like beaten-up funds in other categories, many ultra-short funds own securities tied to the

performance of the housing market and, as it became clearer that that area was running into

trouble, these bonds started flailing. A key force in this downdraft is that heaps of investors

including hedge funds that had owned these securities had to sell them to stay afloat, which further

depressed their prices”4.

As banks and funds liquidated their holdings, the infection spread. This negatively affected

securities only distantly touched by the sub-prime crisis. Eventually even Fannie Mae and Ginny

Mae backed securities found themselves out-of-favor. This, of course, badly affected the asset value

of the funds that held them, including several cash management funds. Even some money market

funds either “broke the buck” or had to be bailed out by their owners.

4
Paul Herbert, Morningstar.com, April 21, 2008.

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The Landscape

In the tradeoff between market and interest rate risk on the one hand and default risk on the other,

cash management funds have generally chosen to minimize the former while taking on more of the

latter than perhaps they realized. Exposure to longer-term securities carries exposure to the following:

1. Market /Allocation Risk – The securities may find themselves with diminished demand, a situation

that was believed more likely for longer duration securities.

2. Interest Rate/Duration Risk – Other than default, the primary risk to the value of debt instruments

is a change in interest rates. A rise in interest rates tends to depress the value of debt and the

longer the duration, the greater the depression.

Cash management funds traditionally have deemed duration risk and market risk of primary importance

and consequently preferred very short-term instruments, even those with higher default risk. Because

these instruments were rolled over frequently, their exposure to interest rate changes was low. Holders

also believed that by pooling their investments they could cut their exposure to default risk while

maintaining an attractive return.

Consequence Examples

An example of a cash management fund is the Homestead

Short-term Bond Fund (HOSBX $225 million). Its holdings

are typical of many funds in this class. It holds securities

with maturities of three years or less. It invests in US

Government securities as well as corporate bonds and

other instruments. Figure 2 shows a breakdown of their

Figure 2 – Homestead Bond Fund cash management
recent holdings. breakdown as of 12/31/09

Source: Homestead Bond Fund

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At least 95% of the fund’s assets must be in AAA, AA, or A

Total Return (Net of fees)

rated bonds. This relatively conservative investment

strategy has protected them some from the worst of the

credit crisis, but their net asset value has been

significantly and negatively impacted as Figure 3

demonstrates. All charts in this report reflect total Figure 3 – HOSBX Total Return net of fees
(3/1/07-8/31/08)
return net of fees.
Source: Yahoo Finance

Two funds that have been more strongly affected by the credit crisis were provided by two of the largest

names in the investment business: Charles Schwab and State Street.

Charles Schwab Yield Plus is a large (more than $600 million in mid-2008, currently $133 million) fund

(SWYPX) that invests primarily in investment-grade bonds. It may, however, invest up to 25% of its

assets in bonds below investment quality, provided they have no lower than a B rating from one NRSRO.

Their investments must have a duration exposure of

Total Return (Net of fees)

one year or less. The Schwab Yield Plus fund is an

excellent example of a cash management fund that

found the higher yields of lower-grade bonds

attractive. For a cash management fund, the results

were disastrous, as Figure 4 shows. The difficulties

Figure 4 - SWYPX Total Return net of fees (3/1/07-
began in August, accelerated in November, and 8/31/08)

Source: Yahoo Finance

became truly severe in March.

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As the fund deteriorated in value, so did its assets under management. Although the fund has nominally

lost about 33% of net asset value, its holdings have declined by nearly 80% during this period. See

Figure 5 for the Total Return results. Schwab Yield

Total Return (Net of fees)

Plus was not the only supposedly safe fund to be hit

hard by the credit crunch. The State Street Yield Plus

short-term bond fund is another example. SSYPX

aimed for high current income and liquidity. It invested Figure 5 - SSYPX Total Return net of fees (3/1/07-
8/31/08)
in mortgage-backed securities, corporate notes, conduit Source: Yahoo Finance

debt instruments, and various asset-backed securities, as well as derivatives of the above. It was shut

down at the end of March 2009.

Much larger than State Street’s fund are Fidelity’s Ultra-Short Bond Fund (FUSFX $310 million) and JP

Morgan’s Ultra-Short Duration Bond fund (JUSUX 275 million). Both have stated investment processes

that are more conservative than State Street’s or Schwab’s. FUSFX seeks a high level of current income

consistent with preservation of capital. It invests 80% of the fund in investment grade securities or

repurchase agreements for those securities. 25% or more of its assets may be invested in the financial

services industry. Its investments have a targeted average maturity of two years or less.

JUSUX has a similar profile, investing in bonds, money market instruments, adjustable rate mortgage-

backed securities, and municipal bonds. It targets a 1-year interest rate sensitivity. As the chart below

shows, these investments turned out not to be quite as conservative as Fidelity or Morgan intended.

JUSUX has lost nearly half its assets under management (through withdrawals and decline in NAV) since

mid-summer. See Figures 6 and 7 below.

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Total Return (Net of fees)

Total Return (Net of fees)

Figure 6 – FUSFX Total Return net of fees (3/1/07- Figure 7 - JUSUX Total Return net of fees (3/1/07-
8/31/08) 8/31/08)

Source: Yahoo Finance Source: Yahoo Finance

An excellent example of the spread of the credit infection “upstream” in mortgage-backed securities can

be seen with TCW’s Short-Term Bond I fund, TGSMX, see Figure 8 for Total Return. Its mortgage-backed

securities are guaranteed by, or secured by collateral guaranteed by the US Government or its

sponsored corporations (Fannie Mae and Freddy Mac). It also invests in AA or higher privately issued

mortgage backed securities. It has assets of more than $100 million. Average duration exposure is one

year.

A November 20 article in Kiplinger5 touted TCW’s Short-Term Bond fund as a fund that was weathering

the crisis, bolstered by its Government-backed securities. The article stated that “the fund has behaved

just as you would expect an ultra-short bond fund to behave. The fund has delivered a modest yield

with virtually no movement in share price”. The article also said, somewhat more presciently, “If the

U.S. housing market collapsed and the backing of Fannie or Freddie became problematic, the TCW fund

would fall hard. But for now, its triple-A mortgage

Total Return (Net of fees)

investments are honest triple-As for the most

part”. As Figure 8 shows, even Government

backed securities were not immune to the

collapse, though they fell later and not as hard.

Figure 8 - TGSMX Total Return net of fees (3/1/07-8/31/08)

5 Source: Yahoo Finance

“Ultra-Short: Still Ultra-Safe?”, Kiplinger.com, November 20, 2007.

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As money market rates have fallen and the asset value of many cash management funds has been hit

hard, two classes of cash management funds have weathered the storm relatively well: ultra-short-term

government-only bond funds and funds investing in variable rate mortgage-backed securities. As Paul

Hebert said in the abovementioned Morningstar article, “investors wondering where to put their near-

term money today have a few options. For the most risk-averse, it makes some sense to revisit money

market funds. They won't lose money, and they'll leave folks a bit better off than if they held their

money in a checking account. Given the low level of rates today, they won't be much better off, though.

Plus, not all ultra-short funds deserve the brush off that the worst of the lot do. Ultra-short government

funds and those focusing on adjustable-rate mortgages have done their jobs during the past several

months. We're fans of funds such as those offered by AMF, for instance”.

AMF’s Short US Government fund (ASITX $64 million) seeks a high level of current income consistent

with preservation of capital and the maintenance of liquidity. It invests only in high-quality fixed and

variable rate assets, primarily of US Government obligations. It targets durations between 1 and 3

years, but has restrictions on neither the minimum nor the maximum maturity of its holdings.

Unfortunately, since the Morningstar article was published, the infection has spread, as the chart below

shows. ASITX has lost half its assets under

Total Return (Net of fees)

management, mostly through withdrawals, see

Figure 9. Nonetheless, the loss of NAV has been

less than in funds with considerable subprime

exposure. We discuss those funds in the next

Figure 9 - ASTIX Total Return (3/1/07-8/31/08)
section.
Source: Yahoo Finance

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Starting in August, 2007, investors started pouring hundreds of billions into money market and cash

management funds that invest in Government-only securities. According to an August report of

iMoneyNet Inc. in the last week of August alone, “…money-market investors overall poured $50 billion

into these Treasury- and government-only funds, while pulling $21 billion out of so-called prime money

markets, which can invest in other securities”.

US Government-Only Funds
This brings us to the funds that invest solely in US Government securities and their derivatives. These

funds are limited to a specific range of maturities. Their past year’s performance is a strong indicator of

the security of the Government only approach.

Among the recipients of the cash pulled from other funds are various ETFs that seek to match the total

return of various duration Treasury products, see Figure 10. Among the largest is iShares Lehman 1-3

Treasury Bond ETF (SHY). It has more than $9 billion in assets. It seeks results approximating the price

and yield performance of the short-term US

Treasury market as defined by the Lehman

Total Return (Net of fees)

Brothers 1-3 Year US Treasury index. It

generally keeps 90% or more of its assets in

the bonds of the underlying index and at

least 95% of its assets in products of the US

Figure 10 - SHY Total Return (3/1/07-8/31/08)
Government. It may also invest up to 5% of
Source: Yahoo Finance
its assets in repurchase agreements

collateralized by US Government obligations or in cash and cash equivalents.

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Very similar in performance is iShares

Total Return (Net of fees)

Lehman Short Treasury Bond ETF (SHV)

with $1.5 billion in assets, see Figure 11.

It seeks to match Lehman’s Short US

Treasury Index (now Barclays Capital).

Figure 11 - SHV Total Return (3/1/07-8/31/08)

Lehman also offers a mixed intermediate
Source: Yahoo Finance

term (1-10 year) Treasury SPDR (ITE).

Its performance over the past year is

Total Return (Net of fees)

very similar to SHY and SHV. See Figure

12 for Total Return

The reason these funds have held up so

Figure 12 - ITE Total Return (3/1/07-8/31/08)

well, and the reason that considerable Source: Yahoo Finance

money has moved into them, is that

the underlying securities have been far

Ten Year Note Yield

less volatile than anything else during

this crisis. The benchmark ten-year

note has had a slowly-declining yield

during this period, a near-perfect

Figure 13 - 10 Year Note Yield (3/1/07-8/31/08)
inversion of the price of ITE, see Figure
Source: Yahoo Finance
13.

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Conclusion

Perhaps the most important lesson is one that has to be periodically relearned: “Their ain’t no such

thing as a free lunch.” It is not possible, over the long term, to receive returns in excess of the risk-free

rate without incurring some risk. That risk may be well-hidden, but it is there. As holders of ultra-short

term bond and money market funds have discovered at their considerable cost, risk is not mitigated by

forming an aggregate of securities with the same risk profile. A bundle of sows’ ears is still not a silk

purse. In particular, the idea that pooling higher-risk mortgages would reduce overall risk has proven as

false as such risk-avoidance approaches have in the past. The effect of such risk pooling is to make the

crash, when it comes, that much worse.

An important takeaway is that while one must assume risk to get higher returns, risk that is predictable

is better than risk that is hidden. And aggregation tends to hide risk. On the other hand, funds that

invest in Treasuries and other guaranteed securities where the primary risk is interest rate change

exposure have fared far better than those that invested in asset-based securities. There is certainly risk

in interest rate exposure, but, as the market has sharply proven over the past several months, that

exposure is far more manageable and far more predictable than the risk of contagious default.

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About Radiant Asset Management, LLC
This paper was written by Radiant’ Chief Investment Officer, David Ross, who has a background in
applied mathematics and investment management with an emphasis on U.S. Treasuries-based stratgies.
It was developed both as part of the research effort to understand the events surrounding U.S. debt and
Radiant’ enhanced return U.S. Treasuries strategy. Mr. Ross previously has run three companies, holds
nine patents, received a BS in Physics from Yale University, did his MS and PhD studies in Aeronautics
and Astronautics at Stanford University and has an asteroid named after him for his mathematics work
at NASA’s Jet Propulsion Laboratory in the Advanced Projects Group.

Radiant Asset Management is an alternative investment management firm formed on the belief
that corporate fundamentals, investor behavior, and market dynamics drive performance.
Original research and proprietary analysis set us apart. We seek superior absolute returns in all
markets.

If you have any comments on the paper, are interested in any further research or speaking engagements
please contact:

Eric Brown Radiant Asset Management, LLC

O: 425.867.0700 15400 NE 90th St.
M: 206.949.1842 Suite 300
eric@radiantasset.com Redmond, WA 98052

Disclosure
This material is directed exclusively at investment professionals. The presentation is provided for
limited purposes, is not definitive investment, tax, legal or other advice and should not be relied on as
such. Investors should consider their investment objectives before investing and may wish to consult
other advisors. Any investments to which this material relates are available only to or will be engaged in
only with investment professionals. Any person who is not an investment professional should not act or
rely on this material.

The information presented in this report has been developed internally and/or obtained from resources
believed to be reliable; however, Radiant Asset Management does not guarantee the accuracy,
adequacy or completeness of such information. References to specific securities, asset classes and/or
financial markets are for illustrative purposes only and are not intended to be recommendations.

All investments involve risk and investment recommendations will not always be profitable. Radiant
Asset Management does not guarantee any minimum level of investment performance or the success of
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Radiant Asset Management or its affiliates. Radiant Asset Management and its affiliates are under no
obligation whatsoever to sell or issue any securities except pursuant to the terms of a duly executed
purchase agreement and related documents.

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