The Money Myth
But one element of the story isn't so widely known: A growing number of small municipalities, including several in Florida, claim they were dupes in the derivatives game. Not only did they lose money on derivatives as interest rates rose last year, but now they're claiming in lawsuits that they were specifically targeted as potential buyers of exotic, low-quality derivatives at inflated, even "unconscionable" markups. In Florida, some of the heftiest derivative losses disclosed to date occurred in Escambia County ($22 million lost on a $44 million portfolio), Collier County ($7.9 million lost on $72 million invested), the Palm Beach Sheriff's Office ($8 million on a $26 million portfolio) and the Sarasota-Manatee Airport Authority ($4 million lost). Escambia County has filed suit in a federal court against four brokerages that sold it derivatives. The county's lawyer, Thomas Tew of Miami, contends that derivatives were inappropriate investments for Escambia because they can be both volatile and illiquid. Indeed, the insurance company for Escambia's auditing firm, Saltmarsh, Cleaveland & Gund, already has agreed to pay $1.75 million to the county because auditors failed to understand the risks of the county's derivative investments. Tew says Escambia was singled out by securities brokerage firms looking to sell their worst derivatives. Sophisticated investors wouldn't touch these investments, he claims, but small counties and towns often had millions of dollars to invest and a hunger for high yields.
"They prey on small government bodies," Tew says of the brokerages that sold derivatives to Escambia. He called the sales pattern "a conscious effort where the toxic stuff was sold to small governments and the filet mignon would be saved for the major underwriting clients."
But last month, an Escambia County grand jury indicted the county's former comptroller, Joe Flowers, on four counts of malfeasance, including a charge that he bought mortgage securities on behalf of Escambia that he wasn't legally authorized to purchase.
Derivatives can be eye-glazingly complicated, and the word has become a catch-all for a variety of different securities. In a broad sense, a derivative is a security whose price depends on the value of an underlying asset. For example, futures contracts are derivatives. When a farmer agrees to sell wheat at a set price three months in the future, the value of the contract depends on whether the price of wheat rises or falls.
For the most part, derivatives sold to Florida municipalities were tied to the value of home mortgages bundled together by the Federal Home Loan Bank System and the Federal National Mortgage Association (Fannie Mae) among other agencies. They buy mortgages from lenders all over the country, then resell them in bulk. But what happens after the mortgages are resold isn't closely regulated.
Fannie Mae, for example, might sell $750 million worth of home mortgages to a Wall Street firm, which then reconfigures the mortgages into different "tranches," with each tranch holding different rights to the income stream generated by the mortgages. After repackaging, the derivatives are sold to investors. The trick is in the repackaging. Even within a single package of derivatives, one tranch can be significantly more volatile than another. Some investors can win if interest rates fall, while others lose.
Also, there is no open trading market for derivatives; an owner is dependent on a broker to negotiate a trade. And the more volatile a derivative, the harder it is to sell. Tew says a small percentage of derivative packages typically have proved to be exceptionally volatile, susceptible to wide swings in value if interest rates rise or fall even slightly. He says major Wall Street firms understood these derivative packages were potentially risky and decided to pass them along instead to small brokerages to sell.
"Small firms got into the game because some of the large underwriters did not deign to sell these types of volatile, ultra-risky securities themselves," says David Berger of Philadelphia, a lawyer for the Palm Beach County Sheriff.
The bulk of derivatives sold to the Sheriff's Office and to Escambia County were inverse floaters. An inverse floater's value depends on the difference between a fixed interest rate and a floating, market-based interest rate. The security performs well when market rates are falling, but it also magnifies the effect of changing interest rates. If rates rise, the value of an inverse floater plummets.
Why would a small municipality buy something so volatile? After all, most government bodies have strict guidelines on risk.
The answer may be ignorance. Morris I. Hollander, a director of the Miami accounting firm Rachlin, Cohen & Holtz, believes county finance officers may have been sold on the notion that derivatives carry little or no risk because they derive their value from government-agency securities. "Nothing could be further from the truth," Hollander says. Mortgage-based derivatives are government-guaranteed as to their interest payments, and principal is repaid in full on maturity. But prior to maturity, their value can gyrate as interest rates change.
Just as the principal value of a U.S. Treasury bond declines when interest rates rise, the principal value of a derivative security can also decline. But derivatives carry even more risk than Treasury securities because their maturities fluctuate, as does the level of interest they pay in many cases. Thomas R. Grady, a Naples lawyer representing Collier County, says his client bought some derivatives with two- to three-year maturities that suddenly became 17- and 18-year maturities when interest rates rose. That's because their maturity was tied to the rate of prepayment on home mortgages. When rates were low, many homeowners refinanced, paying off their existing mortgages in the process. When rates rose, homeowners stopped refinancing and the expected rate of prepayments on mortgages didn't materialize. All this may sound like plaintiffs' lawyers talking, but disinterested financial experts say they don't doubt that some of the most exotic derivative investments wound up in the portfolios of unsophisticated clients.
Mark J. Flannery, Barnett Banks Eminent Scholar in Finance at the University of Florida, suspects that many derivative deals have been sold to "a less sophisticated investor who is willing to pay full price and doesn't understand the risks." Generally, he says, "if you've got something that's really complicated and you try to sell it to somebody who knows what he is doing, you've got to sell it at a lower price." Pat Fishe, chairman of the finance department at the University of Miami, asks, "Has there been misrepresentation that might be construed by some lawyers to be fraud? I'm not an attorney, but one could imagine that in their zeal to sell these products, the risks involved might not have been a major topic of conversation."
Kidder Peabody and other big Wall Street firms have acted as derivative wholesalers, supplying smaller brokerage firms that found municipalities to buy them. Tew, the lawyer for Escambia County, says many of the firms that sold derivatives to Florida municipalities were small and obscure. MGSI Securities, Westcap Securities, Murchison Investment Bankers and Hart Securities, all of Houston, were active in Florida, as were First Montauk Securities Corp. and Meridian Securities. Today, Murchison and Hart are in bankruptcy proceedings.
"Why do the Kidder Peabodys of the world need the Hart Securities?" Tew asks. "The whole Houston crowd, if you think about it, they wouldn't invite to lunch."
The track records of some of these firms are not inspiring. First Montauk, of Red Bank, N.J., sold derivatives to Escambia County. According to the National Association of Securities Dealers (NASD), since 1990 First Montauk has been charged with selling securities without a license in Oregon, charged with "dishonest and unethical practices" by Delaware regulators, fined $17,500 by the NASD for charging unfair markups on securities transactions and ordered to pay a $240,000 arbitration award for churning a customer's account.
Robert Rabinowitz, general counsel for First Montauk Securities, which has been sued by Escambia County, says the county is looking for a scapegoat to shoulder the blame for decisions made by former comptroller Joe Flowers. "We honestly believe based on our records and our discussions with the broker [who sold to Escambia] that they made an informed decision," he says of Escambia's derivatives investments. Rabinowitz says First Montauk supplied Flowers with documentation, analyses and advice about derivatives. "He was not a novice. He was well-educated. He was well-informed," says Rabinowitz of Flowers. Moreover, Rabinowitz argues that Flowers understood that the high returns Escambia earned when rates were falling in 1992 and 1993 came because the county assumed risk. "They knew they were getting higher returns based on assuming increased risks. I think even a novice investor would understand that," Rabinowitz says.
First Montauk makes two other points in its own defense. First, during the years it did business with Escambia, the county's auditors never raised any questions about Flowers' investments, Rabinowitz says. Second, he says First Montauk didn't do a great deal of business with Escambia and didn't know what other brokers were selling the county. If Escambia's portfolio was excessively risky, "you've got to blame him [Flowers] for that. As a broker, you are not necessarily aware of his other investments," says Rabinowitz.
In Palm Beach County, Houston-based Westcap Securities sold the Sheriff's Office $12 million in derivative securities that lost $8 million in value, according to the Sheriff's federal court suit against Westcap. In addition, the suit says Westcap has paid $2.7 million to several Oregon municipalities for selling them inappropriate mortgage-backed securities. Westcap officials did not return telephone calls, but a list of clients that have sued the firm is illuminating. The City Colleges of Chicago say they lost $40 million on a $100 million portfolio of derivatives. The Sarasota-Manatee Airport Authority lost $4 million and has sued in federal court in Tampa. Independence Township, Michigan, lost $6 million. The North Oakland Medical Center lost $10 million on a $27 million derivatives portfolio.
To rub salt in the Sheriff's wound, Westcap allegedly earned at least $1 million in markups, commissions and fees. The Sheriff's Office says it doesn't know precisely how much Westcap earned, but believes "that the true amount of transaction fees earned by defendants ... will reveal an unconscionable and shocking sum."
To be sure, there is sentiment that the extent of wrongdoing by derivatives salesmen is being greatly exaggerated. Derivatives may be more volatile than bonds, but some derivative investments that performed miserably in 1994 have come back in 1995.
Moreover, many municipal investors in derivatives have suffered paper losses only. The entities that have been in serious trouble, like Orange County and Escambia, invested operating funds in derivatives - money they needed within a year. When the market dropped, these investors had to sell derivatives at big losses. But many government entities invested long-term capital in derivatives. Without pressure to sell in a bad market, these municipalities can afford to wait for better market conditions to sell.
Collier County has about $8 million in paper losses on a roughly $80 million derivatives portfolio, but it is concerned it may be forced to cash in the investments at a loss within the next few years. Naples lawyer Thomas R. Grady says Collier County is considering suing the firms that sold it derivatives because the investments were unsuitable. If there is a unifying thread to the stories told by burned derivative investors, it is that they want to put the securities industry on trial for its behavior.
Grady, the Collier County lawyer, says the county lost money on its derivative investments three ways. First, it routinely paid unfair markups on transactions. Grady says he's analyzed about $30 million of transactions out of Collier's $72 million derivatives portfolio and says the county paid $700,000 in excess fees and commissions on those transactions. That's because the county couldn't independently price the securities it was buying; there are no price quotes in the newspaper. Second, Grady says brokers churned the county's accounts, adding that he has identified numerous instances of brokers who sold one security and quickly repurchased an identical one. And Grady says the investments were too volatile and imposed excessive losses on Collier when interest rates rose.
Grady says he isn't sure if Collier officials were misled regarding derivatives: "I don't know the answer to that. What I do know is that Collier lacked the analytical capability to determine the risk or volatility of these securities. Even if the clerk's office understood the general nature of the security, they would have to rely on the broker for advice about its risk and volatility."
The Palm Beach Sheriff's Office claims it was totally dependent on brokers for advice about derivatives. In its suit against Westcap Securities, the Sheriff's office says it "could not, on its own, determine the value or the average or likely term of the derivative securities" recommended to it, enabling brokers "to charge markups for these securities dramatically higher than those charged for less complex securities trading in an efficient, liquid market."
But shouldn't Jerome P. Nolan, the Sheriff's director of administration, have known that in chasing higher yields he was also taking on more risk? Isn't that basic finance?
Snaps David Berger, the Sheriffs' lawyer, "The answer is, he knew it may be riskier than U.S. Treasurys, but he didn't know how much riskier. He didn't have the computer equipment needed to figure it out." If these cases ever go to trial, securities brokers may be asked to explain why they thought derivatives were good investments for small municipalities.
Finance professor Mark Flannery says derivatives can help municipalities hedge against a decline in the value of fixed-income investments when interest rates rise. Flannery says this type of hedging requires a lot of market savvy simply to squeeze a slightly higher yield out of bond investments. Asked if it could ever be appropriate for a municipality to buy derivatives, he says: "Yes, I can imagine it, but particularly in a small county where you don't have full-time money managers, it's probably not a good idea because the risks are so difficult to evaluate." University of Miami professor Fishe says small government bodies may be especially ill-suited to own derivatives because they lack tools which provide up-to-the-minute market information. "You can handle some risk if you are right there with a Reuters or a Bloomberg machine, on top of the securities market every day. But if you are dealing with county commissioners and going to lunch and handling other business, as happens," then a derivatives portfolio can be hard to manage. What's required of brokerage firms that pitch complicated deals to unsophisticated investors? A Wall Street Journal article last October noted that courts have found brokers who sell securities to "unknowing" investors frequently have a fiduciary duty to determine those investors' needs. But can a plaintiff like Escambia County now say it was unsophisticated, when its comptroller, Joe Flowers, told brokers otherwise?
Flowers was a separately elected official whose operations were not under the purview of the county commission. As a result, 75-year-old Flowers had a great degree of independence in his investment decisions. Flowers also signed letters stating he understood well the investments presented to him. But Escambia County Attorney David G. Tucker says neither Flowers nor his staff were well-versed in derivatives - "no one had the sophistication to understand what was going on" - and he believes the securities firms seized on that.
"It's frustrating from the broker's side when you are trying to do the right thing, and you don't get accolades when the investments do well, but the minute things turn around, there is a cry that you are responsible for the downturn," responds Rabinowitz, First Montauk's general counsel.
Tucker isn't sympathetic to that argument. "They took advantage of a kindly old man. That's the bottom line," he says. "They may win, but they'll have to answer in God's court."