One of the largest buyers of municipal derivatives has informed the market he will stop buying such products because underwriters are not providing adequate secondary market support or accurate pricing information.

Dave Johnson, a portfolio manager at Van Kampen Merritt Investment Advisory Corp., sent a letter this week to Wall Street firms informing them of his decision. The market problems Johnson raised led other portfolio managers to question the accuracy of widely reported share prices for mutual funds. Johnson did not address this problem in his letter, the sources said.

Johnson was one of the most active buyers of derivatives and used the securities to help manage risks in Van Kampen's leveraged bond funds, market sources said. The fund declined to reveal the amount of derivatives it owns, but the fund characterized the amount as sizable, but not substantial."

Johnson also works with Wall Street firms to create new derivative products, the market sources added.

The controversy comes on the heels of last week's announcement that Rep. Edward J. Markey, D-Mass., is considering asking the Securities and Exchange Commission for a study of mutual funds' use of derivatives.

Johnson was out of his office yesterday and Van Kampen officials declined to release the letter. But market sources and officials at the firm confirmed its contents.

"We're not pointing any fingers and we're not saying these things are bad," said Bill Grady, another portfolio manager at Van Kampen. "A lot of these products are somewhat proprietary in nature. We're just looking for better information flow."

Managers of other funds and a number of professionals at securities firms agreed with Johnson's assessment of market inadequacies. They said that because derivatives are frequently mispriced in the secondary market, funds holding them would not be reporting correct asset values when marking their holdings to market.

Funds are required to mark their securities to market each day to comply with federal securities laws. Most rely on third-party pricing services for up-to-date prices.

Some managers said they press pricing services to get the necessary information every day, but other managers were unsure how often prices of their derivatives are updated.

Fund managers said they purchase derivatives expressly because the securities are more volatile than ordinary bonds. But lacking up-to-date pricing information, prices on these derivatives may languish unchanged, making the supposedly more volatile securities artificially more stable than the prices of ordinary bonds.

"Here I am, trying to manage the characteristics of my portfolio with these instruments and they aren't doing it because the prices are old or just wrong," one manager complained.

Because many derivatives are structured securities and pay interest based on complicated formulas, the value of a particular security on a particular day can be very difficult to calculate.

For example, many derivatives pay a floating rate of interest that is recalculated every month or every week. But the issuers of those securities pay that interest in cash to investors only twice a year.

Thus, the current yield on such a security on one day would not reflect the accumulated interest since the last payment to investors. Portfolio managers charge that underwriters have not shared enough information on a timely basis to allow for valuing securities with accumulated interest.

Johnson also alleged in his letter that firms that sold him derivatives in the new-issue market did not adequately support those derivatives in the secondary market, said sources who have seen the letter.

"It's kind of scary, really," said one portfolio manager who has purchased substantial quantities of derivatives in the past. "Trying to sell these things is a nightmare - and that's in an up market.

"In a down market, if everyone tried to sell, forget it," the portfolio manager said.

And even some derivatives professionals at securities firms agreed, albeit anonymously.

"This is a legitimate issue. Some firms have not supported their products in the secondary market and have not given information to other dealers to allow [the other dealers] to bid on the securities," one professional said.

In one instance, with a payment date 28 days away, a portfolio manager asked a firm that had sold him a derivative what the dollar amount of the interest payment would be.

"It took 40 calls to get an answer and the answer turned out to be wrong," the portfolio manager said.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.