The Wall Street Journal-20080119-Springfield- Mass-- Takes Aim at Merrill Over Subprime Losses
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Springfield, Mass., Takes Aim at Merrill Over Subprime Losses
In November, officials in Springfield, Mass., got a rude surprise. One of their main investments had plunged in value by more than 90%.
The even bigger shock: This fund was stuffed with risky securities backed by subprime mortgages.
The investment's collapse is now at the heart of a bitter dispute between the city's financial adviser, Merrill Lynch & Co., and Springfield officials who say Merrill violated state law by not properly informing the city what it was buying.
Springfield's losses, because of the collapse in subprime-related debt, follow other hits taken by government-run funds around the country, from Florida to Montana. They underscore how cities and states are emerging as the most recent -- and some of the hardest-hit -- victims of the subprime-mortgage crisis.
"I believe Merrill Lynch is responsible and will be obliged, in the end, to restore the city's money," says Christopher Gabrieli, chairman of the Springfield Finance Control Board, which oversees the city's finances.
Mark Herr, a spokesman at Merrill, said "Springfield has raised these issues with us, and we are taking them very seriously."
At issue is Springfield's investment in a type of security known as collateralized debt obligations, which are pools of debt that include subprime mortgages. The city's stake in three CDOs, valued at $13.9 million as recently as July, plunged in value and are now valued at $1.2 million, according to Merrill's account statements.
The problem, Springfield officials say, is that Merrill fully informed them of the nature of the investment only months after the sales. In November, the firm sent Springfield a document describing the largest CDO, issued by Centre Square, a Cayman Islands-based company. That document revealed that some of the CDOs could be backed by subprime mortgages and might not be easy to sell.
Mr. Herr, the Merrill spokesman, said Springfield officials weren't given the CDO's prospectus last spring, during the sale of the CDOs, because Springfield had purchased them after the initial offering. Under those circumstances, "There was no requirement for a prospectus at the time of the purchase," he said.
The Springfield Finance Control Board argues that state law limits cities to investing in government securities or other safe, short-term and easily tradable investments. While the CDOs were triple-A-rated, they aren't necessarily easy to trade: If there are no buyers for them, then the CDO holder can be stuck with the securities for an extended period.
Some analysts say the brokerage firm shouldn't have sold the city the securities in the first place. "Merrill has to know its customers and sell them what's suitable and appropriate," says Janet Tavakoli, president of Tavakoli Structured Finance Inc., a Chicago-based consulting firm. For Springfield, "These CDOs are not," she said.
Unlike many of the hedge funds, banks and brokerage firms burned by their purchases of shaky mortgage-backed securities, local governments usually lack the staff and resources to make informed decisions on complex investments.
Instead, they lean heavily on ratings firms and their advisers for guidance. Florida officials were forced to close down temporarily the state's short-term-cash fund late last year after local governments withdrew billions of dollars because the fund had invested in subprime-related securities it couldn't sell.
The Montana state fund also said it had suffered more than $300 million in withdrawals. The consequences of a government fund losing money can have a direct impact on schools, police and safety, and other public services. Over time, a municipality might have to raise taxes or cut spending if it loses access to some of its cash.
Massachusetts securities regulators are probing Merrill Lynch about the sale, asking questions about the timing and whether the brokerage firm did enough to warn the city about the risks. The secretary of state has subpoenaed brokers responsible for the sales. The Massachusetts attorney general is also conducting an investigation.
Additionally, the Massachusetts secretary of state has opened a separate investigation of brokers in Merrill's Quincy, Mass., office related to the sale of securities known as structured investment vehicles, or SIVs, to clients in the state. The securities, commercial paper issued by Mainsail II, collapsed in value after Standard & Poor's cut the credit rating from the highest rating to "junk" status.
The office of securities for the state of Maine is also investigating Merrill's sale of Mainsail II paper, sold by the same Merrill Lynch brokers in Massachusetts, to the state treasury.
The losses in Springfield have been particularly disheartening to government officials, as the city has been struggling to reverse a dire financial situation. The city had a $37 million deficit at the beginning of 2004, and six months later the state created the Springfield Finance Control Board to oversee the city's finances. The Board stepped up collection of back taxes and imposed cost controls. These efforts helped turn that deficit into a $30 million surplus by the end of fiscal 2007.
