The drama opened in mid-September with a whirlwind of faxes and redemption orders from investors desperately scrambling to protect billions of dollars.

A presumably safe money market fund run by U.S.-based The Reserve was spiraling down – a victim of the collapse of the Lehman Brothers investment bank, which had just declared bankruptcy.

The net value of The Reserve’s Primary Fund – the oldest fund of its kind in the United States – fell below US$ 1 a share after fund managers were forced to write off US$ 785 million in Lehman debt. Anxious investors ran for the door, flooding The Reserve’s offices with faxes and withdrawal orders.

Among those anxiously rushing to exit was the Chinese government’s sovereign wealth fund, China Investment Corp. (CIC), which held a US$ 5.4 billion stake in the plummeting fund.

More than a month later, the drama was continuing at CIC. The government investor was waiting for a final report on its potential loss from Lehman’s failure. Meanwhile, CIC was fending off critics of its overseas moneymaking strategy, and moving ahead with new investments.

Officials such as Wang Jianxi, CIC assistant general manager and chief risk officer, were surprised after problems with The Reserve surfaced. “Normally, there shouldn’t be any risk, since our investment in the Primary Fund was part of our cash management,” Wang told Caijing.

Others close to CIC said they expected the sovereign investor to lose less than 3 percent of the investment, based on the fact that some of Lehman’s commercial paper held by The Reserve might be redeemed.

Moreover, CIC officials point to a safety net they trust – the U.S. government. “Except for this fund, all of CIC’s money market mutual funds are covered by the guarantee program of the U.S. government, which should ensure no further losses,” a source said.

Redemption Demands

Nevertheless, the sudden change of fortunes for The Reserve stunned CIC and other investors. The Reserve manages US$ 62 billion, and the Primary Fund is considered a safe nest that boasts a guarantee for principal, attracting both individual and institutional investors.

CIC officials awoke to the crisis September 15 when Lehman declared bankruptcy. “Our stage system immediately ordered us to provide a detailed investment portfolio of fund products to make assessments,” said a CIC source.

The next morning, after discovering that Lehman commercial paper was held by the Primary Fund, CIC faxed a redemption order to The Reserve, which returned an email confirmation a few hours later.

The Reserve’s public announcement that night said it would redeem withdrawal requests made by 3 p.m. New York time at US$ 1 per share, while requests received later would be redeemed at US$ 0.97, or the net value published September 16. In effect, all latecomers were to lose 3 percent of their principal.

CIC argued that it had taken action ahead of the mid-afternoon deadline. “We made a timely and accurate judgment this time, and decided to send the withdrawal request before 3 p.m.,” said a CIC source.

But CIC was not the only investor racing to exit the Primary Fund. Soon after the Lehman exposure was detected, The Reserve was overwhelmed by withdrawal requests.

Unable to handle the huge redemption load, the firm applied September 19 to U.S. regulators for a temporary freeze on redemptions. Three days later, The Reserve got permission to postpone investor withdrawal requests until the market stabilized.

But The Reserve’s woes triggered a confidence crisis for money markets, which were flooded with withdrawal orders amid liquidity fears. Within days of The Reserve’s initial announcement September 16, more than US$ 150 billion in funds had fled the market.

On September 29, The Reserve said it would return US$ 20 billion to investors before October 13. But the payback was delayed.

On October 22, a new notice from The Reserve said it would complete the first stage of a redemption process for US$ 25 billion before October 31. The plan covered all investors, regardless of when they sent withdrawal orders. Under this plan, CIC stands to lose up to 3 percent of its US$ 5.4 billion investment.

Lawsuit Pressure

Two weeks before The Reserve changed its mind and decided to spread the pain by denying preferential treatment to early-exit investors, CIC announced it had received from The Reserve written confirmation that all its principal and interest would be redeemed. The investor said The Reserve’s confirmation on its withdrawal request was made before the fund announced a trading halt.

CIC officials said they saw no reason to fear a possible 3 percent loss. They also argued that they have a legal right to all principal and interest.

Just hours after the CIC’s confident announcement, though, The Reserve declared on its Web site that the CIC case would be handled as part of a final liquidation plan, and that the Chinese redemption would come no earlier than other investors.

The Reserve chose to treat every investor equally because it faced lawsuit pressure. Several individuals and institutions started pursuing legal cases, calling The Reserve’s redemption plan discriminatory and a violation of the prospectus.

Strategy Questions

Settling the case of potential losses tied to The Reserve’s fund is not the only worry confronting CIC. Even before the drama began, the government investor was under scrutiny for losing money in other areas. But CIC has clung to its strategy.

Brian Baker, Asia-Pacific CEO for asset manager PIMCO, told Caijing that CIC showed proper caution when it chose to invest in a money market mutual fund that most experts considered conservative.

“The Reserve is one of the largest money market mutual funds,” said Baker. “Who would have expected such a fund would have problems?” Indeed, he thinks CIC acted reasonably by earmarking several billion dollars from its US$ 200 billion capital pool for this moneymaking tool.

And rather than throw in the towel, CIC decided to press forward.

For example, on October 17, through the open market, the firm chose to increase its share in the U.S. private equity firm Blackstone Group to 12.5 percent, even though its initial investment in 2007 has suffered a paper loss.

CIC senior managers have repeatedly said they would stick to long-term investment guidelines in pursuit of long-term returns with adjustments for risk. Indeed, Wang said in March that CIC would hold Blackstone for five to seven years. Now, with additional equity in Blackstone, CIC hopes to win voting rights.

The latest CIC-Blackstone deal is not expected to require approval from the U.S. government’s foreign investor watchdog, the Committee on Foreign Investment in the United States (CFIUS). Blackstone said that, after informal discussions with CFIUS, the regulator would not interfere in CIC’s share boost. Still, the Chinese investor remains on the radar screen.

“CIC increasing its share in Blackstone to more than 10 percent has posed a virtual challenge to CFIUS,” said a source closed o CIC. “What’s the exact attitude of the U.S. toward investors like CIC?”

The drama surrounding The Reserve also paralleled a scramble involving the U.S. investment firm Morgan Stanley, which similarly was rocked by the global crisis.

Speculators in September said CIC might increase its 9.9 percent investment in Morgan Stanley which it bought in 2007. But the Japanese financial group Mitsubishi UFJ ponied up cash to rescue Morgan Stanley, threatening to dilute CIC’s stake.

According to the agreement CIC signed when it first bought shares in Morgan Stanley, the Chinese investor may increase its share to 9.9 percent under the same terms if its equity is diluted by a new investor entry. Technically, Mitsubishi’s investment diluted CIC’s equity to 7.9 percent.

Sources said CIC is now negotiating with Morgan Stanley in hopes of receiving some compensation for share conversions in July 2010.

“The agreed floor for a conversion price was US$ 48.07,” an analyst said. “Its stock price on the secondary market is now under US$ 19 with its future still in question. Therefore, there is a lot of room for negotiation.”

But other analysts said CIC does not have much bargaining space. And the Morgan Stanley issue is just another item on the plate as the Chinese investor grapples with The Reserve over potential losses and jockeys for position at Blackstone.

“The equity increase in Blackstone won’t cost much,” a source said. “But it took place after Morgan Stanley introduced the Japanese fund, which should tell you something.”