WASHINGTON -- The Government Finance Officers Association called for tighter suitability standards for derivatives yesterday after warning that broker-dealers are aggressively marketing these products to states and localities without disclosing the associated risks.

In some cases, dealers are telling state and local officials that derivatives are safe, governmentguaranteed, and provide no risk of loss of principal, Alan McDougle, an association official, told the House Banking Committee at a heating held yesterday on derivatives losses.

Many finance officers believe broker-dealers have "misled" them and "misrepresented" these products either because they did not fully understand the products or were more interested in earning large commissions, McDougle, the director of finance and purchasing for Lima, Ohio, said in his written testimony.

McDougle also complained in his statement that some industry officials, "including some who have appeared before this committee recently," have attempted to prevent association members from adopting policies designeel to warn about derivatives risks and to ensure they are governed by adequate federal standards.

Sources said one industry official tried to grill McDougle about his testimony at his hotel in Washington the night before the hearing. They did not want to disclose the official's name.

At the heating, representatives from Charles County, Md., Odessa Junior College in Texas, and the Eastern Shoshone Indian Tribe in Wyoming all related "tales of woe" about losses from derivatives or structured notes that they said they never would have bought had they understood the risks involved.

Several committee members suggested that the county, college, and Indian tribe had used derivatives and structured notes for speculative purposes to earn above-market yields. They bet against the market and lost, the lawmakers said.

"I'm not sure what case this makes for the regulation" of derivatives, said Rep. Rick Lazio, R-N.Y.

But Roger Fink, an attorney for Charles County, said structured notes issued by the Federal National Mortgage Association and similar organizations are being sold as government securities.

These are not U.S. government securities," Fink said. This kind of marketing, he said, "creates a lot of uncertainty for investors who think [such products] a re fully backed by the government when they are not."

Fink also warned that because many of these products have maturities of 20 or 30 years, they may increasingly be sold in the secondary market to unsuspecting state and local officials.

Fink told committee members that the Securities and Exchange Commission has begun investigating the derivatives sold to Charles County. The county suffered losses after a former official invested almost all of its investment portfolio in inverse floaters, collateralized mortgage obligations, and other risky medium- and long-term derivatives and structured notes between 1992 and 1993.

The city sued about a dozen securities firms, contending these products we're unsuitable and illegal under a state-approved local law. Fink told the committee the county has recovered about $28 million from settlements but is still seeking $8.5 million in ongoing litigation with six other rims.

Philip Speegle, president of Odessa Junior College, said the SEC has also made inquiries about the coltateralized mortgage obligations sold to the college. Speegle said the college has been "scrambling to keep the doors ... open" after watching the instruments, which had a face value of $29 million and were purchased for $22 m,llion, drop in value to less than $10 million.

Speegle, who gave up his salary for pay of $1 a year to save the college money but who wants to retire because of health problems that resulted from the controversy, noted that the mortgage obligations had an AAA credit rating and said he and other college officials thought they were guaranteed by government agencies.

Vernon Hill, a member of the Shoshone Business Council of the Eastern Shoshone Tribe, which has about 3,000 members, testified that a brokerdealer, MGSI Securities Inc. in Houston, aggressively marketed almost $5 million of "mortgage derivative securities" to the tribe, contending they were safe and guaranteed by the U.S. government. Hill said the tribe has suffered losses and has filed a complaint with the National Asseciation of Securities Dealers.

"We don't expect ConFess to protect us from a bad investment," he said. "But we also don't expect the federal government to facilitate a situation where unsophisticated investors can be led to believe that their investment is backed by the federal government."

James W. Ogg, chairman of MSGI Securities, said in a telephone interview later that the charges are untrue and that the tribe business council "was never told these [securities] were government guaranteed." Council members were given 20 pages of material explaining their risks and volatility, he said. Ogg said the council "is not unsophiticated" and hasn't bought far more complex financial products from other brokers in the past.

McDougle disclosed other state and local derivatives losses and said that while derivatives may be appropriate investments for some governments, "for many they are not."

An International Swaps and Derivatives Association spokesman said after the hearing that "losses taken by investors in mortgage-related securities can't be used to justify legislation that would affect privately negotiated swaps and related derivatives."

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.