Schools' Investments Hit by Bankruptcy Of Securities Firm

Article Tools
  • PrintPrinter-Friendly
  • EmailEmail Article
  • ReprintReprints
  • CommentsComments

The bankruptcy of a government-securities firm in New York this month has tied up at least $45 million in investment capital belonging to some 30 school districts in New York as well as to others in Florida, California, and Alaska.

The unexpected development--which also affected some well-known investors, including Arthur Laffer, the economist-champion of "supply-side economics"--has stunned the school districts involved and renewed timeless questions about the intricacies of high finance on Wall Street.

It has also forced state leaders and local officials to reconsider the policies governing how school districts invest their "idle funds," the extra balances they show on their books until the money is disbursed for district operations.

Over the past two decades, states have loosened the traditionally conservative fiscal regulations governing municipal and school-district investments. Their goal has been to encourage more aggressive investments so that the public institutions can reap maximum earnings on government-backed bonds.

The practice of short-term investing by school districts is now "pretty widespread" throughout the nation and is being encouraged more and more because some school districts have had a tendency to "sit on substantial balances," said William H. Wilken, the president of Cost Management Systems, an Alexandria, Va., consulting firm.

Risk vs. Reward

But the school districts that invested their money last year in National Money Market Securities, an Irvine, Calif., money-market fund, discovered this month that the risks of making such investments can be greater than the rewards.

"Governments and districts have been criticized in the past for holding money and not earning additional income," said John Peterson, research director for the Government Finance Research Center in Washington. "Now the pendulum has swung the other way, and in some cases it has swung too far."

Officials from the affected school districts in New York, San Jose, Calif., Dade County and Jacksonville, Fla., and the Kodiak, Alaska, area have in recent days been attending bankruptcy hearings for the Lion Capital Group, a securities firm that handled accounts for National Money Market Securities, to find out how much of their investments they can salvage.

Repurchase Agreements

(A number of counties and cities across the United States also had at least $25 million invested with the bankrupt firm, according to preliminary estimates given by the company in its bankruptcy filing.)

The districts had put some of their idle funds into repurchase agreements, or "repos" in the parlance of money managers.

Repurchase agreements are a common method of borrowing and lending money. A school district, for example, lends money to a borrower--like Lion Capital--in return for securities that the borrower agrees to buy back at a later date at a higher rate of return than the district is likely to get through another form of investment.

In some cases, there is a "middleman" or broker. In this case, Lion was the borrower and National Money Market, which has been in business for two and a half years, was the broker for many of the districts.

The districts lent money to Lion to buy government securities; in return, they received a guarantee that the money was backed by government bonds and that the agreements would be repurchased later at a fixed price, which was to yield the highest returns available at the time.

"A brokerage house in Atlanta recommended the investment to us with assurance that it was backed by government bonds; we have have receipts saying that the investment is backed," said Lewis L. Givens, budget director for the Jacksonville, Fla., school department. Jacksonville has about $4 million tied up with Lion, the most money invested by any of the districts involved in the bankruptcy case.

Simultaneous Claims

But Mr. Givens and other school officials said that although an investor may have guarantees, when a judge declares a business bankrupt under chapter 11 of the federal bankruptcy law, the creditors are essentially at the mercy of the bankruptcy court, which is required to "divvy up the assets" of the firm.

The situation is further complicated, district officials said, because a firm that Lion apparently used as a depository for the safekeeping of the districts' securities, the Bradford Trust Company, has claimed that the assets do not belong to the districts because the securities were collateral for a loan that Bradford made to Lion Capital.

The school districts are arguing in the U.S. Bankruptcy Court for the Southern District of New York that they have "prior right" to the collateral for their loan to Lion, according to Arthur S. Olick, a senior partner with Anderson, Russell, Kill, and Olick, the law firm representing the school districts.

The two judges who have been conducting the bankruptcy hearings granted a request by the lawyers to bring the case to trial in late June and to examine the books and records of both Bradford Trust and Lion Capital.

Bond-Market Problems

Lion's bonds have been liquidated and invested in Treasury bills to avoid having creditors' money further depleted by the bond market, which has taken a steep downturn since January, according to Mr. Olick.

According to Gerard Miller, director of technical services for the Goverment Finance Officers Association (gfoa) in Chicago, the bond market has "dropped like a rock" since the beginning of the year. Dealers in government securities, "once in a good leverage position," have seen the price on long-term government bonds drop 12 percent, he said.

The Lion case is similar to a 1982 bankruptcy of a government-securities firm that jeopardized $350 million in repurchase investments made by the New York Dormitory Association, according to Jeffrey B. Noss, vice-president and manager of municipal research at Roosevelt and Cross Inc., an investment firm in New York City that underwrites bonds for school districts throughout the state.

The assets of the bankrupt firm's securities were held as collateral, Mr. Noss said, adding that after a delay the Dormitory Association received about 97 percent of the money back but lost about $17 million plus interest earnings.

What apparently happened in both the Lion Capital and Dormitory Association cases, Mr. Peterson of the government-finance research center said, was that municipalities and districts invested in intermediary agencies that did not hold government securities but were simply "under agreement to purchase them."

"The government funds may or may not be backed up with the actual physical holding of security," he said.

Probe by Attorney General

Currently, New York State Attorney General Robert Abrams is conducting an investigation to determine whether National Money Market Securities, Lion Capital, and Bradford Trust Company violated the state's security laws in their handling of school districts' funds. The inquiry, which is being conducted by the New York City office of the attorney general, was requested by officials from the districts and by Gordon M. Ambach, state commissioner of education, according to David M. Fishlow, a spokesman for the attorney general's office.

"If any of the participants of these transactions knew that the districts' funds were not properly safeguarded and failed to disclose that," they would be in violation, Mr. Fishlow said.

"What appears to have happened is that securities paid for by districts were used as collateral for loans from Bradford to Lion." Among other possibilities, the state is seeking to determine "if Lion used bonds which were not its own to collateralize loans which it knew it wouldn't be able to pay back," according to Mr. Fishlow.

The situation involves a "complex series of financial transactions" and it may be "a matter of months" before the investigators are ready to decide if the situation should be brought before a grand jury, he said.

Investment Guidelines

James E. Vaccaro, superintendent of the Amherst Central School District in New York, had some $625,000 tied up with Lion Capital. He said that prior to dealing with Lion, his district--and all other New York districts--had received letters from both the state comptroller and the state education department saying that the investment company met "all the necessary rules and regulations."

"We get quotes from all the upright, legitimate firms we can do business with," Mr. Vaccaro said. "We look for the most favorable rates. At that particular time, Lion was quoting the best price."

An opinion released in 1982 by the New York State Comptroller's Office stated that New York school districts could utilize the services of brokerage houses to invest in U.S. government securities. A 1983 decision said that districts could utilize an investment advisor, such as the National Money Market outfit, according to James P. Rourke, who has been school-bond advisor for the New York State Education Department for nearly 20 years.

Say Warning Was Issued

But, according to Pamela Orzechowski, a spokesman for State Comptroller Edward V. Regan, the comptroller's office warned districts about the hazards of repos in a newsletter last January. That warning was evidently "not read or not heeded" by the districts involved, she said.

As a result of the Lion bankruptcy, Mr. Regan on May 10 sent a letter to local government officials urging them not to invest in repos. Concurrently, Mr. Regan sent a letter to Commissioner Ambach to warn school districts not to invest in the repurchase agreements, Ms. Orzechowski said.

Mr. Rourke said that earlier this year he wrote a letter to some districts "reiterating" the comptroller's statement approving the use of National Money Market Securities.

Mr. Vaccaro said that the state comptroller's office must "rethink guidelines for granting approval" to specific investment firms. The state will also "have to issue new guidelines so that there is better protection for municipal and district investments."

Disagreement on 'Repos'

Mr. Noss, the Roosevelt and Cross analyst, suggested that districts ''would be wise to limit their investments to larger, more nationally known firms," such as large commercial banks. He also advised districts to move away from repurchase agreements, which generally provide up to 1-percent higher returns, in favor of 90-day Treasury bills.

But Mr. Miller of the gfoa advised that districts and municipalities continue to invest in "repos." The fault was not with the form of investment but with the specific details of the agreements, he said.

According to Mr. Miller, such agreements should include guarantees that transactions will be "overcollateralized" to protect the creditor in the event of bankruptcy or insolvency. He also said that when government bonds are used as collateral and the market falls, a securities dealer should promise to set aside more collateral to cover the loans on a daily basis.

"Repurchase agreements made by districts should be suitably documented and in the third-party hold of a major bank or the Federal Reserve," according to Mr. Rourke, the New York school-bond advisor. But Mr. Rourke said he runs a "one-man shop" and "doesn't have time to police everything."

Some 700 New York state school districts earned more than $100 million from short-term investments in 1982, he said.

State Oversight

According to The Bond Buyer, a New York-based daily trade paper for the municipal-bond industry, some states do not have the responsibility to oversee local investment practices. California, New York, and Texas allow their municipalities to invest in repurchase agreements. Mississippi, on the other hand, only allows them to put money in "repos" Continued on Following Page

Vol. 03, Issue 35

Notice: We recently upgraded our comments. (Learn more here.) If you are logged in as a subscriber or registered user and already have a Display Name on, you can post comments. If you do not already have a Display Name, please create one here.
Ground Rules for Posting
We encourage lively debate, but please be respectful of others. Profanity and personal attacks are prohibited. By commenting, you are agreeing to abide by our user agreement.
All comments are public.

Back to Top Back to Top

Most Popular Stories