Investments: Profit in Rancho P.V., Loss in Lawndale

When E. F. Hutton talks, Rancho Palos Verdes listens--very carefully.

Last January, the city’s new treasurer discovered that his predecessor had invested about $1 million with a Hutton broker in a speculative securities deal. The amount represented about one-fifth of the city’s total investment funds.

Several months later, the value of the investment plunged by half and city officials threatened to sue Hutton, alleging that the company failed to inform the city about the risk. According to sources in city government, the two sides made a deal:

Hutton would give the city its $1 million back, plus some interest, and both sides agreed to keep quiet about the settlement.

Same Kind of Investment

Lawndale has not been as fortunate. In late September and early October, the city learned during a routine audit that its part-time treasurer, Ray Wood, had made the same kind of investment with the same Hutton broker. City officials decided to pull out of the deal, and Lawndale was scorched to the tune of more than $1.6 million--about half of the city’s general fund reserve.

“We were out of our league,” Lawndale Assistant City Manager Paula Cone said in a recent interview. “Way out of our league.”

If there is comfort in numbers, Lawndale found plenty of it. The cities of San Marino and Palmdale, which shared the same treasurer as Lawndale, disclosed that they had lost about $6 million altogether in the same type of investment. The Three Valleys Municipal Water District in the San Gabriel Valley later reported it lost $1.5 million in a carbon-copy deal. Bellflower lost $290,000.

In La Verne, city officials invested $630,000, later realized the risk and bailed out just in time. City Manager Martin Lomeli said the city even made a small profit.

“We just got lucky,” Lomeli said.

Hutton declined to comment except to say that the losses were caused by the fall in the bond market earlier this year. Hutton was initially involved in all the transactions until its broker, William E. Parodi, moved to another firm and took three of the city accounts with him.

Parodi, who initiated contact with all the cities and put together the deals, defended the investments and said in an interview that he made sure that officials in each city understood the risks. He contended that if the cities had not terminated their investments when the bond market was at a low ebb, they may not have lost any money.

Wood, who also was fired as San Marino treasurer and resigned as finance director in Palmdale, has declined to comment specifically about the investments except to say he made “an error in judgment.”

“I didn’t realize what was happening until I was trapped,” Wood said in an interview shortly after audits uncovered the investments.

The losses came before the recent stock market crash and were not caused by problems in the market. Instead, it appears that the municipalities’ losses occurred when interest rates climbed earlier this year. When interest rates rise, the value of existing bonds tends to drop because investors can get a higher return by buying new bonds.

Buying on Margin

What got Lawndale into trouble, city officials say, was that it purchased the securities on margin. In a margin account, an investor puts down only a fraction of the price of the security, hoping the market will rise. If it does, the investor can sell the securities and make a profit without ever paying the full price. But if the price of the security falls more than the amount invested, the investor has to put up more money or lose everything.

Here are the key dates in the Lawndale debacle, based on interviews and a chronology released this week by City Atty. David Aleshire:

Sept. 29-30, 1986--Wood wires $300,000 to an E. F. Hutton brokerage to open an account after initially being contacted by Parodi during the summer. On Lawndale’s behalf, Hutton purchases $6 million in government bonds on margin. Lawndale contends that Wood was not told that the bonds were bought on margin.

March 20, 1987--The city’s account is transferred, with Wood’s approval, from Hutton to another brokerage company, First Investment Securities Inc. The transfer occurs after Parodi resigns from Hutton and joins First Investment.

April 9--Lawndale’s accounting supervisor gets a phone call from First Investment instructing the city to wire $253,646 to the company to meet a margin call. Wood approves wiring the funds. According to the city, the margin call is Wood’s “first indication” from Parodi that the city’s investment involves margin trading, and he instructs Parodi to close the account once Lawndale’s investment is recouped.

April 13 and 21--The city receives two additional margin calls for a total of $485,000. Wood authorizes payment.

Sept. 3--The city receives another call from First Investment, saying the city would have to meet another margin call for about $265,000 within a week. About the same time, Wood contacts First Investment, saying the city wants out of the investment and “made whole”--financial jargon for getting back all the money--within 60 days.

Sept. 8--The margin call comes. Amount: $263,381.50. Wood authorizes payment. At the same time, Wood informs City Manager Paul Philips about the latest margin call, and tells him that the city’s investment is good if the bonds are held until they mature in the year 2014.

Sept. 9--Yet another margin call is made, this one for $336,000. Wood, on a trip to New York, gets a call from city officials and approves payment.

Oct. 1--Lawndale council members meet and are told by the city’s auditors about the investment and margin calls. The council decides not to meet any more margin calls. Wood is fired.

Oct. 2--Aleshire sends a letter to First Investment telling the company that the city is closing the account. He demands that all city funds be returned.

Oct. 7--First Investment closes account and wires $244,094.85 back to city--the present value of the account minus brokerage fees. The bottom line, according to Arthur Young & Co., the city’s auditing firm, is a loss of $1.67 million--$64 for each of the city’s 25,000 residents.

Parodi, 46, was “permitted to resign” from Hutton in March and went to First Investment Securities Inc., taking with him the Lawndale, Palmdale and San Marino accounts. When a broker leaves a firm, the Securities and Exchange Commission requires that the company report whether he or she left voluntarily, was discharged or was “permitted to resign,” Hutton spokesman Steve Nelson said.

In a telephone interview, Parodi said he left Hutton after officials at the firm became aware that he was “looking around to move to another firm.”

“We just agreed I would resign,” Parodi said.

Stress-Related Disability

Parodi, who said he left First Investment, an Arkansas-based company with an office in Woodland Hills, in September because of a stress-related medical disability, said the city officials who put their money into the investments were fully apprised of the risks involved and understood the investment.

“In our minds, they have to be knowledgeable and understand the program” before the investment is made, Parodi said.

In a letter to Redondo Beach Treasurer Alice DeLong last March, Parodi stated that First Investment cannot “call the market right every time and sometimes your securities may be worth less than what they were purchased for.” And La Verne City Manager Lomeli said Parodi did indicate to city officials that “there was some risk” in the investment.

Never Fully Explained

Rancho Palos Verdes officials will not talk publicly about their dealings with Hutton or Parodi. The settlement approved by council members was done in closed session, and the city agreed with Hutton not to disclose the final arrangement, sources said. The same sources said the investment was similar--if not identical--to the one placed by Lawndale and the other cities and water district that lost money.

But officials of the Three Valleys Municipal Water District and Bellflower contend that the risk was never fully explained to them. “As far as we are concerned, the city was relying on the expertise from E. F. Hutton” and was given improper or poor advice, said Bellflower City Atty. Maurice O’Shea.

Lawndale officials have said they will also attempt to retrieve the city’s funds through negotiations with Hutton. The city has suggested it will allege that neither Wood nor any other city official was told of the risk.

In a move aimed at preventing such losses from recurring, the Lawndale council has adopted what City Atty. Aleshire called an “extremely conservative” written investment policy. The policy limits city investments to passbook savings accounts, certificates of deposit, U.S. government securities and the state-run Local Agency Investment Fund. Any other type of investment requires council approval.

In addition, the council adopted an ordinance transferring the duties of finance director from the city manager to the assistant city manager. The ordinance is designed to improve the checks and balances within the treasurer’s office by, in effect, having one more person review the city’s monthly treasurer’s reports. Before, the reports went directly from the treasurer to the city manager and then to the council.

Lawndale previously did not have a written investment policy--even though state law requires city treasurers to file such a policy with the city council.

Said Assistant City Manager Cone: “It slipped through the cracks.”