O.C. Crisis Puts New Focus on Brokers’ Role
Star salesman Michael G. Stamenson of Merrill Lynch & Co. had a pat answer when he was asked whether securities he sold to the city of San Jose in 1987 were too risky for a municipal portfolio.
“Risk,” he said, “means different things at different times to different people.”
That remark by Stamenson--who was Merrill Lynch’s principal contact with San Jose when the city came close to bankruptcy in the mid-1980s and later played the same role in Orange County’s investment fiasco--speaks volumes about how Wall Street has viewed the rest of the world, including the public institutions that make up a significant part of its clientele.
“The normal presumption is, ‘If they’ll buy it, we’ll sell it,’ ” says Samuel Hayes III, a professor of investment banking at Harvard Business School. “And they’ll do it without a second thought that there’s some hidden tripwire out there that will make the whole thing explode.”
Until now, that is.
Possible Conflicts of Interest
The financial disasters that have detonated within public investment funds over the last few years--with Orange County’s $1.7-billion loss the most spectacular--are focusing unprecedented attention on the marketing practices of Wall Street’s giant investment firms.
At issue is whether full-service firms such as Merrill Lynch--which typically create securities for one client and then sell them to other clients, collecting a fee at both ends--have inherent conflicts of interest in which the clients’ welfare may rank second to the firm’s own prosperity.
Meanwhile, as the securities industry’s products have become more complex--and the pressure on brokers to pitch them to large investors has intensified--critics are questioning whether investment firms owe even purportedly sophisticated municipal clients better disclosure about the risks of what they’re buying.
“The brokers are sales people with very little training and no particular expertise in these flashy new securities that are coming out,” says Frances F. Goins, a Cleveland lawyer pursuing cases against investment houses that sold highly volatile, risky mortgage-based securities to two counties and a city in Ohio.
“What you have,” she says, “is an arrangement where customers think they have a knowledgeable and expert investment adviser--and what they’ve really got is a refrigerator salesman.”
For their part, Wall Street firms have long operated on the view that institutional investors--unlike everyday retail customers--know the risks of whatever they are buying.
“At some point, you’re no longer dealing with a gray-haired, widowed grandmother; you’re dealing with an institution where the guy in charge has been doing it for years,” says Robert Connor, a New Jersey money manager who frequently testifies as an expert witness in brokerage lawsuits.
Nowhere do all these threads converge as tightly as in the $525-billion market for securities of U.S. government agencies--the Federal National Mortgage Assn. (Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac), as well as the Student Loan Marketing Assn. (Sallie Mae), the Farm Credit System and the Federal Home Loan Banks.
These agencies inject grease into the national economy. By using their borrowed capital to buy home mortgages from banks and other lenders, Fannie Mae and Freddie Mac alone are thought to reduce prevailing mortgage rates by as much as a quarter to a half percentage point. Sallie Mae and the Farm Credit System perform similar roles in the student and agricultural loan markets. Developers, home buyers, college students and farmers, whether in Orange County or anywhere else, benefit from the lower interest rates these alphabet-soup agencies make possible.
But the agencies’ securities--created and then brokered by Wall Street bankers--also were among the riskiest securities Orange County bought for its disastrous portfolio. These were “structured notes,” so called because their quarterly or half-yearly dividend payments are computed according to elaborately structured formulas involving interest rates or other variables.
That Orange County loaded up on agency notes is not surprising. Because they enjoy the implied, though not formal, full faith and credit of the U.S. government, these securities can be marketed as nearly free of credit risk--and therefore “safe.” That virtual guarantee has helped the agencies, which are government-sponsored but for the most part independent, become the biggest players in the structured-note market. In 1993, the last year for which complete figures are available, they accounted for 69% of the $86 billion in structured notes issued nationwide.
But there’s a rub. To call these securities risk-free is a misnomer. Some are so complex that their performance in volatile interest rate markets can prove unpredictable. As long ago as last July, Aida Alvarez, the top federal regulator of the housing mortgage agencies, warned investors to look hard before buying too much of this paper.
“The bulk of these securities do not involve unusual market risk,” she said, “but some do, and the message here is ‘buyer beware.’ ”
That’s a message that Orange County contends in a $2-billion lawsuit was too rarely sounded by its leading investment broker, Merrill Lynch.
Merrill may have had more than a bystander’s interest in seeing that such securities got sold. In many cases, Merrill had designed the notes, persuaded a government agency to issue them and then arranged to sell them to its institutional clients.
Take as an example the life cycle of a note issued by Fannie Mae and underwritten by Merrill Lynch on Feb. 3, 1994. The interest to be paid by the $400-million note was based on a complicated formula involving the London Interbank Offering Rate, a common interest-rate benchmark; starting three years after its issue date, the note would pay more if interest rates fell and less if they rose.
Because investment banking fees rise sharply in tandem with the complexity of the note being issued, Merrill was able to charge Fannie Mae an underwriting fee of $2.25 per $1,000 issued, or a total of $900,000. That is as much as four times what the firm might have been able to charge for underwriting a conventional fixed-rate note.
Dual Role for Brokerages
Merrill sold the entire $400-million issue to then-Orange County Treasurer Robert L. Citron for the county’s investment portfolio, profiting on that transaction from the difference between what it charged the county and what it remitted to Fannie Mae.
That Merrill Lynch collected fees and earned profits at each step helps explain why it was such an enthusiastic promoter of such securities--as are most major Wall Street firms. “Almost always, the initiative for these deals comes from the investment banks,” says Jay Roy, who as president of the Federal Home Loan Bank of Pittsburgh is one of the overseers of the home loan banking system’s debt issues.
But when the same firm is intimately involved in all facets of the market, questions are inevitable about whose interest is being served in the marketing of complex securities.
“An investment bank is in a situation of conflict of interest by definition,” says Harvard’s Hayes. “It’s always been a fine balancing act to obtain the best they can for a corporate customer without shafting the ultimate buyer.”
In Merrill’s dealings with Orange County, the brokerage made far more in fees from the agencies issuing securities than it did on its sales to Citron.
Figures provided by the firm to a state Senate subcommittee this month show that in 1993, Merrill earned profits of $8.1 million from quasi-government agencies for underwriting and hedging notes later sold to Orange County, and another $2.1 million from the sales themselves (as well as from underwritings of the county’s own bonds). In 1994, the firm made $1.7 million in profit from underwriting government issues later sold to the county, and another $300,000 from the sales themselves and county underwritings.
As Merrill’s principal contact with the county, Stamenson earned a salary of $240,000 and bonuses of more than $2.5 million in 1993; the following year, he earned the same salary and about $1 million in bonuses.
Merrill has vigorously contended that it repeatedly warned Citron his overall portfolio was excessively risky; in March, 1993, the firm even offered to buy back all the structured notes it had sold Orange County up to that time, at a substantial profit for the county--and a large potential profit to the firm, if interest rates stayed low, as they did for another eight months.
Merrill followed up in late February, 1994, with a written analysis full of explicit warnings that a looming rise in interest rates would cause major losses for Orange County.
And yet, as little as two weeks before issuing that analysis, the firm had sold Citron another $400 million in risky notes. Four months later, it would underwrite a $600-million county borrowing designed explicitly to finance the purchase of even more.
It isn’t just investment houses whose conduct is being challenged. The quasi-government lending agencies are themselves becoming unnerved by rising criticism over their role in the structured-note food chain.
“Over the last two years, the agencies have become more concerned about some of their more volatile securities falling into the wrong hands,” says Ted Dumbauld, a trader of agency securities at Deutsche Bank in New York.
In part, that worry represents fear of a political backlash: Any move to force the agencies to cut back on the variety of securities they issue will mean higher borrowing costs--and that, they say, will mean higher costs in the end for home buyers, students and farmers.
“This is an aspect of our borrowing that we feel is important to sustain,” says Timothy Howard, chief financial officer of Fannie Mae, who argues that high-risk notes, in any event, typically account for only about 1% of the agency’s $250 million in annual borrowing.
Who, then, is to keep risky business from falling into the wrong investors’ hands? The agencies say they have no choice but to rely on the investment banks to ensure their securities are being sold to suitable buyers.
“We’re not in a position to assess an investor’s risk,” says Vicki Whittenton, vice president and treasurer of Freddie Mac.
“We expect the (investment banker) to know his customer, and the customer to have the ability to understand the instrument and to be authorized to make the investment,” says John K. Darr, chief of the office of finance at the Federal Home Loan Bank system, another heavy issuer of structured notes.
Disclosure of Risks Questioned
From Orange County to the East Coast, however, several recent cases suggest that “know-your-customer” rule is often overlooked when it comes to the firms’ relationships with institutional clients, including local governments.
Morgan Stanley & Co. and the state of West Virginia, for example, are arguing over who deserves blame for a $190-million loss the state suffered in 1986 and 1987. (Seven other investment firms settled with the state out of court; only Morgan went to trial, at which it lost a $48-million judgment it is appealing.)
Morgan insists that it was only following state officials’ own investment strategies and that it found those officials to be highly experienced.
At trial, however, the evidence included one telephone conversation in which Morgan’s chief options executive asked the state director of investments--a former secretary named Kathryn Lester--if she needed to “walk through the steps” of a transaction they had completed a week earlier.
“Do I need help?” she replied. “Do bears go in the woods?”
In dealing with Lester and one other state official, the state charged, Morgan improperly loaded West Virginia’s portfolio with options deals, reverse repurchase transactions and advance purchases of U.S. Treasury bonds that went sour. A state judge ruled that some of these transactions violated West Virginia law, which prohibits speculative investments by the state.
As for that phone call, state lawyers say Lester mistakenly believed the deal--a “put” option on $100 million in 10-year Treasury notes--obligated the state to sell the securities to Morgan; in fact it obligated the state to buy them at a set price, even if their market price declined in the meantime. When Morgan exercised its option two months later, the state was forced to buy the securities at a loss of $6.8 million.
Investment experts say similar questions about investment experience are likely to play a growing role in disputes between Wall Street firms and their institutional clients, such as Orange County. Indeed, the experts say, the complexity of some of today’s investment products makes any representations about their riskiness misleading.
“Some of these securities are so hard to value that nobody can make adequate disclosure” about their safety, says Alan Bromberg, professor of securities law at Southern Methodist University Law School.
That already seems to be the conundrum in the Orange County imbroglio, in which Stamenson and Citron have so far given sharply differing public versions of their relationship.
In testimony before the special Senate committee last month, Citron--who served as treasurer for 24 years--called himself a lay person who relied on advice from Stamenson and other brokers in making his investment decisions.
Stamenson countered that any advice he provided was purely informal. “We were never a financial adviser,” he said. “We told our clients what we thought was going to happen. It was our opinion. We shared our opinion.” As for Citron, Stamenson said, “there is no doubt that he was and is a highly sophisticated, experienced and knowledgeable investor. . . . I learned a lot from him.”
But the Merrill Lynch salesman also acknowledged to Sen. Lucy Killea (I-San Diego) that he did not see the giant investment house’s role as telling Citron what to do.
Stamenson said: “We were a purveyor of products, Senator.”
Hiltzik and Vartabedian reported from Los Angeles, Paltrow reported from New York.
