Toomre Capital Markets LLC ("TCM") earlier in 2007 was quite worried about liquidity risk and the level of risk premiums that investors were assuming through their various investment strategies in the proverbial search of yield or return. Interested readers might perhaps want to reread the February 12th 2007 TCM post entitled Hedge Funds, Investment Banks and the Value of Liquidity? where we wrote:

Economic times presently are pretty good world-wide. When the inevitable turn in the vastly more inter-connected global economy next comes, credit spreads surely will widen and the valuation of various financial instruments will come under stress. Are hedge funds (and by proxy the investment banks) prepared for coming "Great Unwind" forecast by Mr. Stiamann and Knips? Some hedge funds inevitably will do very well then, while others will fail, perhaps as spectacularly as Amaranth Advisors did in September 2006.

The financial markets now are full of much liquidity. Are investors, speculators and their bankers appreciating and pricing in liquidity risk? Toomre Capital Markets LLC would suggest that liquidity risk presently is greatly under-valued in the search for "alpha", absolute return and portfolio yield. The stretch to get ten percent return (after fees) appears to be making rational people start to do irrational things.

Sadly, many institutional investors did not heed this warning about the then insane pricing of liquidity risk. Over the past week, Lars Toomre has had the chance to catch up some of his much neglected reading. Several stories in particular are noteworthy in the context of liquidity risk and the consequences of reaching for yield. Lars will try to complete write-ups in the next few days about several of these sad tales to remind future investors of the consequences of investing in something not well understood for the promise of that incremental return or enhanced yield.

This first write-up regards four Norwegian municipalities that have suffered large losses from leveraged investments. In the story Hedge Fund Scandal Rocks Norway, FINalternatives.com has details of four small, very northern Norwegian municipalities (Rana, Narvik, Hemnes and Hattfjelldal) that have suffered large market losses from investing in what is described as a credit-focused hedge fund organized by Citigroup and marketed by Terra Gruppen. According to the article, "The hedge fund, Citigroup Municipal Investors, required municipalities to assume debt which was then secured by future energy revenues. However, the subprime credit crisis in the U.S. hit the fund hard, and the municipalities, four of which invested a total of $739 million, were forced to place more money into the funds or face losing their investments. According to reports, one small town couldn't even make payroll for December and was forced to cut child care and elder care programs. 'It’s not legal to market hedge funds in Norway,' Eystein Kleven, a representative of Norway’s regulatory agency Kredittilsynet, told newspaper Aftenposten. [Local] Politicians are taking the brunt of the blame from the public, though they are scrambling to place fault on Terra, claiming that they were tricked by the firm and that the investments Terra sold were illegal."

The Reuters article Norway Probes Big Investment Losses By Four Towns describes the towns' investment a bit differently. Apparently these were "Structured municipal portfolio fund-linked notes", whatever the heck those are. Apparently, these notes, "which were based on debt issued by U.S. cities and states, had high credit ratings. To boost returns the investments were leveraged by short-term loans taken out by the four towns… To satisfy margin requirements on the leveraged assets the towns have been obliged to make further payments on their investments. The [Norwegian] government has so far refused to offer financial assistance to them. 'The government cannot be a safety net for failed investments by Norwegian municipalities,' Finance Minister Kristin Halvorsen told reporters on Wednesday."

Toomre Capital Markets LLC probably would described as a sophisticated financial firm. However, we generally do not consider it prudent to invest in municipal structured notes where the ultimate payoff is levered and somehow tied to energy prices. Did Citigroup and Terra Gruppen really think small municipal investors would fully appreciate the risks that they were bearing for some promised incremental yield? Had these institutions forgotten the 1994 lessons of Bankers Trust and the complex derivatives sold to Proctor & Gamble and other large corporate accounts? Had these institutions learned nothing from the 1994 experience of the Orange County California investment account?

Toomre Capital Markets LLC is continually surprised by what normally sane institutions do in their reach for incremental return. Perhaps these municipalities did not fully understand all of the risks that they were exposed to. However, why did they think in the first place that they were qualified to invest in high-grade United States municipal securities? And why did either of the brokers involved think that these municipalities were qualified to make such investment decisions? Reader comments and thoughts are welcome.