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Eye of the Storm: Subprime Global Freefall: SMA, Mutual Fund Execs Face Reality at MMI

BOSTON-The worldwide, far-reaching ramifications of questionable subprime mortgages in the United States should have been foreseen and could have been prevented, separately managed account and mutual fund executives concurred at the Money Management Institute's annual conference here earlier this month.

As a result of the lack of foresight on Wall Street about potential derivatives, futures and other synthetic products' risk, the underpinnings of global investor confidence have now been shaken and will take years, potentially decades some doomsayer economists warn, to repair. When someone loses their house or their home, it gets their attention, and people understand it has something to do, at least, with bad mortgages.

"There were clear and fundamental flaws that we should have seen in advance," said Mark Fetting, president and chief executive officer of Legg Mason of Baltimore, one of the keynote speakers at the meeting, titled "Innovations in the Managed Solutions Industry."

"Clearly, these credit products were concocted by a food chain on Wall Street," Fetting said. "The credit crunch is a good reminder that when we have the ability and tools to examine these products, we need to make damn sure they're going to work over the long haul."

Subprime mortgages, like junk bonds, are more volatile and pay higher yields than regular mortgages because of the increased risk that borrowers won't be able to pay off their loans. Riskier borrowers pay higher rates, and as long as they make their payments, traders of these mortgages can see higher profits.

When the going was good, when housing prices continued to climb, in some markets at an incredibly fast rate, borrowers were able to refinance their loans at more attractive rates. Sometimes they didn't even bother to do so, because the overall economy was so strong, and like mutual fund investors who fail to rebalance their portfolios, mortgage borrowers just let their banks "set it and forget it."

Now, of course, soaring real estate values in many markets seem too good to be true, but at the time, Wall Street firms joined in the party and kept dancing until the music stopped.

When the housing bubble popped last July/August, hundreds of thousands of people, particularly those with balloon or adjustable-rate mortgages, discovered all of a sudden to their, and their bankers', absolute dismay that they were no longer able to afford their homes. Lenders have been scrambling since then to cover the losses.

"We all have a little sin here, and we will continue to pay for a while," said Paul Hatch, managing director and head of Global Wealth Management Investments for Citi Global Wealth Management. "The credit crunch has damaged the trust we have with our clients. Who was responsible? It doesn't matter now."

Damage & Destruction'

Yet to Be Fully Seen

The investment management industry should remember the importance of due diligence and understand that risk is not risk-free, Hatch stressed.

"We have an awesome burden to explain risk to clients," he said. "It is our burden to make certain we agree what those risks are. As partners, we need to work our way out of this together. The damage and destruction we have seen hasn't been reflected in the equity markets yet."

Hatch said the industry has to evolve and the solutions have to be integrated. Fund companies should stop focusing on solving their own problems and start focusing on providing solutions for clients, the Citibank leader said.

"[Separately managed accounts] will always be enormous part of what we do, but they won't be the only part," Hatch said. "SMAs are very valuable, but at times, mutual funds provide a richer set of solutions. The challenge as an industry is to keep adding value. Don't lead with performance, because you'll die with performance."

Investors are scared by volatility, and the investment management industry should be working to eliminate that fear by helping investors understand risk, he said.

"We are going to keep seeing the kind of things we just saw," Hatch said, referring not only to the subprime crisis but to the quick-turn shortsightedness of decades past-from the 1950's "Nifty Fifty," to the 1960's video-telephones, to VHS and Betamax in the 1970's, Mike Milkens' junk bonds famously in the 1980's and phantom dot-com "eyeball" profits in the 1990's.

"We need to make sure these solutions don't compromise investor integrity. A crisis can make allegiances stronger, but the fear of risk can cause clients to be more conservative than they should be."

"In the near term, these are very difficult markets for our clients," Fetting said. "Over a five-year period, we are hoping we will deliver strong performance with improved support on a broader, global scale."

This will include productive partnering between distribution and manufacturing, he said, but the intent is to provide sustainability, not a short, unsustainable surge.