CHICAGO - Scores of local governments in Ohio have invested in high-risk instruments that may violate state law, according to the state auditor's office.
The governments, which include counties and school districts, have lost millions of dollars by investing mainly in interest-only, stripped mortage-backed securities, according to published reports.
John Conley, a spokesman for the Ohio auditor's office, said the office has identified "scores of public entities in Ohio that may have problems with these high-risk investments."
Conley said the use of the investments was discovered in late spring and early summer as audits were being done on the governments' finances.
In an Oct. 12 audit bulletin to local government officials and public accountants in the state, Ohio deputy auditor Bruce R. Dern said the investments may be in violation of state law.
According to the bulletin, the law specifies that investments by governments must mature or be redeemable within two years from the date of purchase or be obligations of or guaranteed by the United States or carry the pledge of the United States.
Dern said that "at this time," the auditor's office believes the stripped mortage-backed securities "are not suitable and do not comply" with state law.
Conley said the auditor's office was not releasing the names of the governments whose investments are being questioned in the audits. However, the office will begin releasing completed audits next month, he said.
He said the auditor's office is also looking into local government investments in principal-only, stripped mortgage-backed securities and collateralized mortgage obligations.
The Plain Dealer in Cleveland has identified some of the governments that have invested in the type of securities mentioned by the auditor's office. They include Portage, Preble, Putnam, Sandusky, Seneca, and Van Wert counties and the Strongville School District.
Officials at both Moody's Investors Service and Standard & Poor's Corp. said they were unaware of the investment problems, but would look into the matter. While Standard & Poor's only has ratings on insured debt issued by the governments that have been mentioned in press reports, Moody's mainly rates unenhanced debt sold by some of the governments.
Angela Connelly, a senior analyst at Moody's, said the agency would have to determine the extent of the investment losses and what their impact is on the governments' financial condition.
At least one of the governments, Sandusky County, has filed suit against the Houston-based brokerage firm that sold it the investments.
The suit, filed Oct. 19 in U.S. District Court in Toledo, charges Government Securities Corp. of Texas and a senior vice president of the firm with federal and state securities fraud. It also lists Government Securities Corp.'s clearing firm, Donaldson, Lufkin & Jenrette Securities Corp., and Colson Services Corp., a New York City-based investment advisory firm as defendants.
The charges come in connection with the county's purchases since 1990 of three types of securities: Federal National Mortgage Association interest-only securities; Small Business Administration receipt for multiple originator fees, a secondary market mortgage-backed security; and Fannie Mae inverse floaters through Government Securities Corp.
The inverse floaters were sold to the county in 1992 as a hedge for the interest-only securities, which had been losing value as interest rates dropped, the lawsuit says. The suit does not indicate what investments the county currently holds.
Sandusky County claims that its treasurer, Virgil Swartzlander, was not aware of the riskiness of the investments until the state auditor obtained and shared with Swartzlander a document from Government Securities Corp. that listed the investments as "100% risk."
The lawsuit contends that had Swartzlander or the county known how risky the investments were or that the securities were "not issued or guaranteed by the federal government" as required by state law, those investments would not have been made.
The county charges that the defendants provided "false information" on the securities, and "abused the position of trust they had purposefully established with the plaintiffs, causing plaintiffs harm in the form of money damages and potential liability to others."
While the lawsuit is seeking damages totaling more than $50,000 for each count, court documents do not indicate how much the county lost on its investments.
Meanwhile, Government Securities Corp. made a preemptive strike against the county on Sept. 29 when it filed suit against the county in U.S. District Court in Houston. The lawsuit seeks a declaratory judgment clearing the securities firm of any wrongdoing. It also requests an injunction barring the county from filing a complaint with the National Association of Securities Dealers, the Texas Securities Board, and any other regulatory agency.
In the lawsuit, the firm claims it maintained an investment portfolio of about $15 million to $20 million for the county and that it only sold or offered the county government securities. Government Securities Corp. contends that the county did not question the legality of the investments until recently, after the county sustained losses in its investments because of "changing economic and market conditions" and the county's "failed investment strategy."
The lawsuit contends county officials failed "to exercise reasonable care and competence in communicating information" to the firm regarding "appropriate and legal investments" for the county.
"The actions of Sandusky County officials were in bad faith, wanton and reckless," the lawsuit charges.
Frank Klaus, an executive vice president at Government Securities Corp., read a statement saying the firm filed the lawsuit after "good faith efforts to amicably resolve this matter without litigation" were unsuccessful. He said it is company policy not to comment further on litigation.
A spokeswoman from Donaldson, Lufkin & Jenrette and an official from Colson Services Corp. said yesterday that they did not believe their firms have been served notice of the lawsuit.
An attorney for Sandusky County did not return phone calls.
At least one other government in Ohio has done business with Government Securities Corp. Harold Merkle, treasurer of Van Wert County, said his predecessor, Lloyd Basil, had bought Fannie Mae interest-only securities through the firm. Merkle said the county hoped to sell "the slightly less than" $500,000 of the securities this week through Smith Barney Shearson. He added that the county expects to lose a yet to be determined amount of money on the deal.
Seneca County Treasurer Marguerite Bernard said the county was no longer making investments currently being questioned and declined to comment further.
Barbara Suggs, treasurer of Preble County, said the county invested in $358,000 of interest-only securities through Hart Securities in Dallas. The county transferred the account to Paine Webber Inc., which gave the county a $75,000 settlement on the investment late last year, Suggs said.
"We're no longer involved in that," she said, referring to the interest-only security investments.
David Spialter, business counsel in the Ohio attorney general's office, said the office is in the process of collecting information about the investments. He said the legality of the governments' investments may have to be determined on a case-by-case basis.