Town’s Safe Investment Led to Risks and Losses : Securities: One-fourth of $5-million value disappeared in derivative transactions. Fund denies misleading its clients.
Gambling with $5 million was just about the last thing on Jon Elam’s mind.
So the administrator of Maple Grove, Minn., seeking to invest the money until it was needed for street repairs, chose what seemed like a safe bet: a top-rated mutual fund that held only government-backed securities and that was pitched as ideal for everyone from municipalities to retirees.
Now, this suburb of single-family homes and cornfields 20 miles northwest of Minneapolis has lost a quarter of its original $5-million investment and Elam is smarting.
He isn’t alone. Leaders of several Minnesota communities--and 7,000 other investors around the country--lost money, and many charge the fund’s sponsor, Piper Jaffray Cos., with deceiving them about the investment.
“No one suggested it was higher risk,” Elam said in a phone interview from his office in Maple Grove’s city hall. “They said it was ideal for governments who want to take a minimum of risk.”
In fact, the managers of the Piper fund--the Institutional Government Income Portfolio--mostly invested not in ordinary securities but derivatives, among Wall Street’s least understood and most complicated instruments.
Piper, whose fund has plunged about one-quarter in value this year, denies it misled investors. Indeed, many corporations and brokerage firms use derivative transactions not for speculative purposes but to hedge against financial volatility.
But the surprising plunge in the Piper fund cuts to the heart of an increasingly vocal debate: whether everyday investors accustomed to the security of bank savings deposits are sufficiently informed about the volatility of arcane financial tools.
The worst derivatives losses hit only a handful of the more than 4,600 mutual funds and a small portion of the fund industry’s $2.1 trillion in assets. And to mitigate the damage, about a dozen mutual fund companies, brokerages and banks have spent millions in recent months to bolster their funds.
But small investors may have yet to learn the problem’s full extent.
“The little guy doesn’t know it yet. They will know it when, ‘Gee, I think I want to sell. . . . Gee I can only get 70 cents on the dollar now,’ ” said Jim Somers, who owns an asset management firm in Radnor, Pa.
The Piper Jaffray fund was hardly for average Americans--the minimum starting balance was $25,000--but it nonetheless attracted thousands of investors, including several small Minnesota cities that already were clients of the Minneapolis-based investment firm.
Assets in the Institutional Government Income Portfolio soared from less than $200 million in January, 1992, to $827 million at the start of 1994.
Elam, who approved the city’s $5-million initial investment two summers ago, said the Piper Jaffray prospectus gave few clues about its emphasis on derivatives--complex transactions in which payments are based on, or derived from, some pre-agreed benchmark, such as interest rates.
A key paragraph in the 1993 prospectus lists preservation of capital as a main objective. It says the fund invests in “United States Treasury bills, notes, bonds and other obligations issued or guaranteed as to payment of principal and interest by the United States government or agencies.”
The prospectus does mention a large portion of mortgage-backed securities in the portfolio, and said it had the freedom to purchase such investments as “inverse floaters.” But in a world of financial jargon, that term for a type of derivative didn’t sound any alarms with Elam.
“Just the title of the fund, Institutional Government Income, speaks to what the goal is,” said Elam, recalling his impression at the time. “Perhaps I was naive, but I didn’t think that every fund that pays a higher return is automatically risky.”
Indeed, the Piper fund soared 15.6% last year, outperforming the 72 other short-term U.S. government bond funds in its category, according to Lipper Analytical Services Inc. The Morningstar mutual fund research company awarded it five stars, its top ranking.
What was juicing up the fund’s yields, though, weren’t plain vanilla bonds but diced and recombined versions of mortgage-backed securities dependent on the cash flows from home loans.
Bonds based on home mortgages tend to have a relatively low default risk mainly because the payments are guaranteed by various federal government agencies--including the Government National Mortgage Assn., or Ginnie Mae, and the Federal National Mortgage Assn., or Fannie Mae.
But derivatives of these securities can plunge in value when interest rates change direction, upsetting assumptions made by market players about prepayments by holders of home mortgages.
That’s what happened in February, when the Federal Reserve unexpectedly raised rates for the first time in five years. The sudden increase sharply diminished the number of homeowners seeking to refinance their mortgages with new loans.
The upheaval forced portfolio managers, corporate treasurers and other large holders of exotic mortgage-backed securities to dump the derivatives, sharply driving down their market value.
The drop in the Piper fund was steep: It tumbled nearly 30% from early in the year to May, when Piper announced it would inject $10 million into the fund and closed it to new investors. The fund has since recovered a bit but was still down about 23% through August.
Investors stunned over the losses are suing for unspecified damages in federal court in Minneapolis.
“Most of them are very angry and very distressed. A large number of them have invested retirement savings, or they’ve invested money they need to live off of and are watching the money disappear on them,” said Gregg Fishbein, a Minneapolis attorney representing investors.
Piper Jaffray said through a spokeswoman that it believes the fund’s disclosure is adequate and it would vigorously defend itself against lawsuits.
Elam, who has fielded numerous questions from residents about the community’s well-publicized loss, said Maple Grove cannot afford to sell its fund shares and take a $1.2-million loss on its investment. But the community is fortunate because the $5 million wasn’t immediately needed, he said.
Moreover, the city continues to receive a dividend check each month from Piper for $33,000, nearly 8% on the original investment.
“I don’t have any personal malice toward Piper,” Elam said. “Their loss is even greater than ours.”
