DALLAS -- A Texas junior college that lost millions of dollars in high-risk derivatives when it failed to comply with state investment laws has undertaken corrective actions recommended by the government.

The state auditor's office issued a report last week containing findings of a three-month inquiry into the investment practices of Odessa Junior College, whose involvement in derivatives triggered a crisis forcing the school to increase its debt and tuition.

Odessa invested $22 million -- nearly all its cash reserves -- in highrisk, mortgage-backed derivatives, as valued by the state auditor's office on Aug 31. Rising interest rates reduced the value of the school's portfolio substantially, leaving Odessa with relatively illiquid investments it cannot afford to sell.

The auditor's office concluded that the 4,500-student college did not exercise proper oversight over investments and failed to ensure compliance with state investment law, specifically the Public Funds Investment Act.

The report said the school's board of trustees did not develop a formal investment policy or receive annual written investment reports as required by law.

The report also said that while the college's independent auditors verified that the investments were legal they did not verify compliance with other requirements of the investment act.

Odessa Junior College has begun work to deal with the problems that emerged because of its involvement in the risky derivatives.

"Management generally concurs with the findings and recommendations contained in this report," the auditor's office said. "They have included corrective actions they have under-taken to implement some of the recommendations."

Gary Johnson, a school trustee, said work is under way to deal with the institutions's problems connected to derivatives.

"Many of the recommendations in the state report were suggested by Odessa College, including other suggestions that were not in the report," he said in a statement. "Most of the recommendations have already been implemented by Odessa College some time ago."

Mel Schonhorst, an executive at First Southwest Co. in Dallas and financial adviser to Odessa, said the report was "very specific direction and advice to make sure this kind of situation doesn't happen again."

The college, responding to the auditor's office recommendations, has put into place a written investment policy addressing the school's liquidity needs and clearly setting the board of trustees' expectations for portfolio diversification, allowed investments, fund restrictions, weighted average maturities, collateralization, authorized personnel, reporting, and standards of care.

The college also requires periodic written investment reports to monitor compliance with its investment policy and state laws.

The report said the college president and the board of trustees may have lacked sufficient information and training to understand investment risk.

The investments were made by Roger Coomer, the school's fiscal officer, who resigned last summer.

The college's board was aware that the school's investments were earning an abnormally high rate of return from 1991 to 1993, ranging from 11.59% to 24.84%, the auditor's report said.

The board "stated that they questioned the vice president of business affairs about the college's ability to generate substantially higher investment returns than other junior colleges," the report said. "He stated that the other junior colleges were not earning high rates of return because the investment officers simply did not understand these types of investments."

The report said the school began sinking money into derivatives in 1991 without implementing investment management controls and its top officials probably did not fully understand the inherent risk.

The payoff for the risky investment plan was rich for a while. In 1993, for example, Odessa's return on its investments reached $4.3 million.

But as 1994 unrolled, interest rates climbed and the value of the college's investments eroded. Since January, in fact, the value of Odessa's portfolio shrank 50%, the state auditor's office said.

"Odessa College's investment cash flows have declined significantly as interest rates have risen and investment maturities have extended," the report said.

The college lost $3 million during fiscal 1994 from a sale of a portion of the portfolio.

"The unpredictability of principal and interest cash flows made these types of investments difficult to manage for budgeting and short-term operational needs," the report said.

To help cope with the financial crunch, Odessa has had to resort to stiff measures. The school issued $10.75 million in taxable bonds, raised the property tax rate by 7.2%, increased tuition by $4 a credit hour, and scrapped its tennis and men's track teams.

Following Odessa's fiscal troubles, credit rating agencies downgraded the school. In September, Moody's Investors Service lowered the college's revenue bond rating to Baa from A.

Standard & Poor's Corp. downgraded $13.8 million in consolidated fund revenue bonds issued in 1985, 1989, and 1992 to BBB-minus from A-plus.

Derivatives are financial instruments whose value is tied to the performance of something else. Odessa's derivatives were tied to collateralized mortgage obligations.

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