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Managers: Subprime Blame Lies With Rating Agencies

Fund managers at Morningstar's conference say credit raters are the problem.

Bond funds may have a reputation for being boring, but anybody who attended Morningstar's annual mutual fund conference in Chicago last week might have the impression that the fixed-income market is the most dangerous part of the U.S. financial system right now.

Both the opening and closing sessions featured tough-talking bond fund managers who pulled no punches about the state of the subprime mortgage market and about who was to blame for the mess.

"It's an unmitigated disaster," Jeffrey Gundlach, chief investment officer at TCW Group, said during the conference's opening address. "And it's only going to get worse."

Gundlach said that he expects to see more delinquencies in loans made to borrowers with poor credit histories and that the subprime mortgage market's woes would lead the

Federal Reserve

to cut interest rates.

The fund manager said he doesn't believe many of his peers hold debt backed by subprime mortgages. Nevertheless, the rising number of bad loans could have a broad effect on the credit markets because so many banks are exposed to it.

"One should not be a buyer of bank debt," said Gundlach, who was named Morningstar's 2006 Fixed-Income Manager of the Year for his stewardship of the

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TCW Total Return Bond Fund (TGLMX). The fund, which carries Morningstar's highest rating of five stars, posted a return of 5.3% in 2006, beating its category by 1.1 percentage points. So far this year, the fund is up 0.75%.

"People thought they had triple-A bonds with low risk," Gundlach elaborated during a press conference that followed his address. "They didn't think that they had high-risk resecuritizations. Most of these bonds shouldn't have a triple-A rating."

The TCW Total Return Fund's portfolio allocates 16% of its assets to triple-A-rated mortgage pass-through securities, which are bonds backed by pools of mortgages, and 75% to triple-A-rated collateralized mortgage obligations, which are more complex mortgage-backed securities. However, Gundlach says he doesn't hold any of this poor-quality debt.

The same themes were reiterated two days later at the conference's closing session among three bond fund managers who agreed with most of what Gundlach said.

"What happens to subprime going forward is a debate between bad and horrible," said Keith Anderson, chief investment officer of fixed income at


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. "But we have not invested in them in our mutual funds or institutional accounts."

Anderson co-manages the

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BlackRock Bond Investors Fund(MDHQX), an intermediate-term bond fund with a two-star Morningstar rating. It earned 3.8% last year and is down 0.23% year to date.

He plants the blame for the subprime mortgage mess firmly at the feet of the bond rating agencies, saying, "they are a huge concern."

"These ratings are artificial because they have been relying on recent historical prices in a rising market," the fund manager said. He added, "You will find the investors in these instruments are either hedge funds or leveraged accounts, but the vast majority is overseas."

Robert Rodriquez, chief executive officer of First Pacific Advisors, was even more blunt. "We haven't seen much of a problem in the subprime area

but only because the pricing is a fraud; the ratings are bullshit," said the two-time recipient of Morningstar's Fund Manager of the Year.

"I don't buy these prices, but as long as someone can provide capital to keep the finger in the dike, the charade will go on."

Rodriguez concurs with Gundlach that rising subprime mortgage delinquencies are a problem not just for hedge funds but also for major banks and other financial institutions.

"It is estimated that U.S. banks have invested 10% of their assets in collateralized debt obligations," he said. "And 40% of the CDOs are in subprime

mortgages. I'm trying to get details on the components and I can't get any. This is setting up the next catastrophe."?

Rodriguez co-manages the


FPA New Income fund (FPNIZ), which gained 4.8% last year and is up 2.13% year to date. It also carries a two-star rating from Morningstar.

Rodriguez anticipates a huge drop in the prices of both long-term and high-yield debt and avoids both in his portfolio; as a result, it currently has about 41% of assets in cash. This cautious approach may temper gains, but it also reduces volatility: The fund hasn't suffered a calendar-year loss since Rodriquez took charge in 1984, according to Morningstar.

Stephen Walsh, the deputy chief investment officer for Western Asset Management, voiced similar concerns. "There's been a complacency among investors," he said. "I read that 50% of the (subprime mortgage) loans were low- or no-documentation loans, just state your income without any proof. "

Walsh said he didn't understand how anyone could analyze the risk in holding loans when borrowers have little or no equity in the property and there is no way to verify their ability to make payments. However, he said he stayed away from these securities not because of a "doomsday scenario" but rather because of a lack of faith in the analysis.

"How do you make an assumption on a loan that is undocumented?," Walsh said, referring to the lack of documentation of a borrower's employment or income for many subprime loans.

Walsh co-manages two intermediate-term bond funds, the

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Western Asset Core Plus (WACIX) and the

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Western Asset Core Bond Institutional (WATFX), which both received five stars from Morningstar. The Core Plus Fund rose 6.6% last year and is up 0.1% in 2007, while the Core Bond Institutional rose 6.2% in 2006 and has also gained just 0.1% year to date.