Are American pension funds affected by the sub prime mortgage crisis? And how deeply? A definite answer may come only in a few months. In the meantime there is a lot of denial together with suspicion and fear. For sure, investment banks have been offering RMBS (Residential Mortgage-Backed Securities), CDOs (Collateralised Debt Obligations) and other riskier investments to US pension funds in the last fout to five years, and some have bought them to spice up their performances in an age of very low interest rates. But nobody knows yet the exact amount of the problem and the real quality of the bonds that have ended up into pension funds’ portfolios.

According to a recent report by Bloomberg News, in the past five years US public pension funds - the ones sponsored by states and other public administrations - have bought more than $500m in CDO equity tranches, which are the bottom and riskier slice of a bundle of bonds backed by debt, including home loans such as sub prime mortgages, issued to households with a very poor credit history or to those termed “NINJA” (No Jobs No Income No Assets). These tranches are called “first loss” or even “toxic waste” because as more borrowers default on loans, these would be the first to take losses.

Few pension funds admit having “toxic waste” in their portfolio. The $245bn (€181bn) California Public Employees’ Retirement System (CaLPERS), the nation’s largest public pension fund, has indeed invested $139m three unrated CDO portions. “It represents 0.06% of the total fund market value as of 30 June, 2007 and that’s very small exposure to CDOs,” points out CalPERS spokesman Clark McKinley. “We made the initial investments in early 2004 to take advantage of attractive conditions in the credit market. To date, investment returns in the three deals have been between 16% and 27%, with no write-downs of our investment as defaults have been very low.

“In our global equity programme, of which hedge funds are a sub-asset class, we are not directly invested in any hedge fund that focuses its investments in CDOs or any type of mortgage security”. Besides that, CalPERS owns about $2.5bn in securities that are backed by sub prime loans, but McKinley stresses: “They are all AAA-rated, unlike other bonds that are subordinated and below our AAA holdings in the capital structure. We are well protected in this case and not at risk”. No worry then?

Another famous California based investor, the bond guru and PIMCO managing director Bill Gross, disagrees. In a recent investment outlook he argued that in many cases the current AAA ratings of RMBS and CDOs are not as safe as they used to be. “Many of these good looking [bonds] are not high-class assets worth 100 cents on the dollar,” he declared. “The point is that there are hundreds of billions of dollars of this toxic waste and whether or not they’re in CDOs or Bear Stearns hedge funds matters only to the extent of the timing of the unwind”.

Among other pension funds holding CDOs is the $82bn Ohio Public Employees Retirement System that has about $530m worth of investments in sub prime
mortgages, or 0.64% of its assets. The fund’s managers said they were not concerned because it was “a relatively small portion of to the overall portfolio”, but the Ohio Retirement Study Council, a legislative panel that monitors state pension fund, will discuss the issue at its next meeting in September.

The $62bn Oregon Public Employees Retirement Fund - a pioneer in private equity and alternative investments - has invested 2.4% of its bond portfolio or 0.5% of its overall value in securities backed by sub prime loans. The General Retirement System of Detroit bought three equity tranches for $38.8m; the Teachers Retirement System of Texas owns $62.8m and the Missouri State Employees’ Retirement System holds a $25m equity tranche. They all stress that these holdings weigh very little on their total assets.

Other pension funds, such as the $154.5bn New York State Common Retirement Fund, the $107bn New York City’s five pension funds and the $12.4bn Illinois State’s three retirement funds, declare they are not invested in any CDO. Still others are betting they can take advantage of the current turmoil, finding bargains in undervalued securities, including sub prime mortgages and other credits. Last July the $16.7bn San Francisco City & County Employees Retirement System decided to invest $25m into Los Angeles-based TCW Group’s special mortgage credit fund. Along with a general reshuffle of its portfolio, the $29bn South Carolina Retirement System is planning to invest $100m through a money manager looking for sub prime mortgage opportunities.