Merrill Lynch's dealings with Springfield have spawned a probe by the state attorney general.
(Mike Segar/Reuters)
SPRINGFIELD - Trouble has a way of finding this long-struggling city. But in November 2006, when Springfield financial officials found themselves with a multimillion-dollar surplus of cash for the first time in years, it seemed as though their troubles were behind them.
Not for long. Just 10 months after placing some $50 million with Merrill Lynch & Co., those same officials would be scrambling to explain how they'd lost nearly $13 million on investments so risky that state law bars cities and towns from owning them - investments linked to the subprime mortgage collapse that has rocked Wall Street and world markets.
"There are no more aggressive sellers in this business than the investment banks," state Treasurer Timothy Cahill said in an interview about the Springfield losses. "Generally they have an advantage when they go into a city or town."
In this case, Merrill Lynch - the firm that bet the most on the subprime market and was about to lose the most - was clearly in the driver's seat. Merrill wasn't a mere broker ped dling investments to Springfield. It was the creator of these complex securities, the seller, and the sole calculator of their value.
And there is evidence that Merrill did not fully disclose the nature of the investments until it was too late.
To be sure, Springfield officials should never have allowed this investment to take place. But their correspondence with Merrill shows that they were confused about what they had agreed to. Merrill's dealings with Springfield have spawned investigations by Secretary of State William F. Galvin and Attorney General Martha Coakley, and inside Merrill Lynch itself.
Christopher Gabrieli, chairman of the control board that oversees Springfield's finances and a former candidate for governor, said, "It's fairly clear that Merrill offered us and sold us something clearly unsuitable for us, and not something we were eligible to buy."
Bill Halldin, a Merrill Lynch spokesman, declined to say whether the investments were appropriate for Springfield, saying only, "We are conducting an extended review of the circumstances of these transactions and expect to respond further to the city shortly."
At Springfield City Hall, the first clue that something had gone terribly wrong came last July, on a monthly statement from Merrill Lynch - and it was subtle. The names of three investments worth $13.9 million in its account had suddenly changed. Now, each one had the acronym "CDO" tagged onto its name.
A large investment that had been called Centre Square Ltd. - at least through June - was now called Centre Square CDO. Two other, smaller investments also had their names changed. CDO is shorthand for collateralized debt obligation, a security based on a portfolio of sliced-up bonds and loans. In this case, the underlying portfolio included mortgage-related securities.
There were reports detailing record home foreclosures and concerns about credit ratings on CDOs. And there were dire warnings of losses to come at Wall Street's investment houses, which had loaded up on these arcane investments and were now repackaging them and selling them to individuals, not just to large, sophisticated investors.
The full pain of the wreckage would not come until later in the year. Merrill Lynch has now rung up losses of $7.8 billion in 2007, written down the value of $24 billion in investments and ousted its chief executive as a result of the debacle. And around the world, losses from subprime mortgages and the securities built around them have hit an estimated $170 billion.
Merrill Lynch said it could not explain why the names of Springfield's investments changed last July. But the timing of the disclosures was more than a little curious.
By August, the market value of Springfield's three CDO investments had fallen 25 percent, on paper. By the end of September, they had plunged 50 percent, according to Merrill Lynch's calculations. And at the end of November, the original investment of $13.9 million was marked down to less than $1.3 million.
Springfield officials were slow to react. Letters between the city and Merrill Lynch's legal department dealing with rudimentary questions about the CDOs were penned in November and December, long after the losses had hit. It wasn't until November that officials would learn the details of Centre Square - a "CDO of CDOs" registered in the Cayman Islands and put together by Merrill and a New York hedge fund firm, Petra Capital Management.
Centre Square was a $462 million portfolio created by Merrill Lynch out of CDOs it owned. Wall Street firms were creating such vehicles in droves, according to analysts and rating firms. For a fee, Petra Capital repackaged the securities into the Centre Square entity, and Merrill Lynch then sold the new securities to its clients.
Merrill Lynch was also the underwriter of the other two CDOs it sold to Springfield. Springfield was not a first-round buyer in any of the CDOs, Merrill said; the city bought into them only after the large institutional investors who first bought them sold their holdings.
It is up to a city's treasurer to make sure its investments are appropriate, according to Cahill and other officials who are responsible for city or state monies.
Springfield Treasurer Salvatore R. Calvanese's signature appears on the Merrill Lynch account documents.
But there were four people in the room when Merrill Lynch and two other Wall Street firms made their pitches in November 2006 for the city's cash management business, including Calvanese and the man who is now executive director of the control board, Stephen Lisauskas. The state-run control board, which has overseen Springfield's finances since 2004, did not review the investment decision, current and former board members said.
The bidding process was informal, documents obtained by the Globe in a public-records request show. In fact, there was no competitive bidding process by the city, but rather a decision to invite the three firms to make presentations.
A local broker for Morgan Stanley brought charts showing typical returns for government bonds and money-market funds, in the 4.6 percent to 5.3 percent range. A Springfield broker from UBS Financial Securities Inc. showed similar products, and included in his proposal a copy of the Massachusetts statute that limits municipalities' cash investments to safe, conservative accounts.
Such funds, the law states, should earn the "highest possible rate," while taking account of "safety, liquidity, and yield." Specifically, the money should be invested prudently, at a low risk of loss, and should be in accounts that the city could cash out of within 365 days.
The third broker, Carl J. Kipper, came from Merrill Lynch's Albany, N.Y., office. Kipper knew Lisauskas, having worked with the control board member's wife in the past. Kipper brought a package that showed rates no higher than 5.2 percent. The choices were unglamorous - money markets, US government debt sold by the Treasury, and highly rated debt from large, well-known companies.
Nowhere in his proposal did the words "collateralized debt obligation" appear.
The city of Springfield's lawyer, Edward M. Pikula, said city officials did not receive or read a written description of Centre Square until Merrill's assistant general counsel, V. James Mann, sent the 235-page offering document to them in November, in response to concerns raised by the treasurer.
Said Pikula, "There is no written record of a financial disclosure [of the CDOs] until the private placement memorandum of Nov. 29, 2007."
Had they read it earlier, they would have seen on page 13 that Centre Square securities could involve "a high degree of risk and are intended for sale only to sophisticated investors who are capable of understanding and assuming the risks involved." In addition, the memorandum said there could be "no assurance" of a market to exit the securities.
Reading a prospectus is a basic duty of a treasurer before making any investment, a number of city and state officials said. Calvanese declined to be interviewed. But city officials and lawyers briefed on the situation said Calvanese and others who weighed in on hiring Merrill Lynch relied on the firm's assurances that the investment met the legal standard for safety and prudence.
In Mann's Nov. 29 letter to Calvanese, he said, "The current lack of liquidity for this security was not anticipated at the time the City made its investment - it results from an unexpected confluence of market conditions."
He said that, until August, it had been possible to trade in and out of Centre Square and other CDOs, but that the market had dried up, making it impossible to sell the securities without taking a loss.
The losses on the city's books are, for now, paper losses. That is, there is no real loss unless the city were to sell the CDOs now for a poor price. In theory, if the city holds onto its investment until, and if, the market improves, it could recoup the original funds it invested. To date, the investment is still paying income, as promised, because the underlying mortgage notes are still earning interest.
It appears from letters between Calvanese and Merrill Lynch that the treasurer took Centre Square's AAA ratings - the highest available - to mean the investments were low-risk. It's a common misconception with these complex securities; in fact, the rating agencies are evaluating the likelihood of the security to keep paying interest and principle on time - not the market value of the security itself.
It's a little like assessing the ability of a homeowner to make his or her mortgage payments. That's separate from judging the market value of the homeowner's house - or whether it can be sold at all.
This month, Standard & Poor's, the bond-rating agency, put a number of CDOs, including Centre Square, on a negative watch, meaning there is now concern about those income streams going forward. The AAA ratings remain for now.
Michael D. Conrad, treasurer and collector for Worcester, said he hires only banks to manage that city's cash.
"I don't know a lot about these CDOs," Conrad said. "We all got somewhat educated by the fact of what happened in Springfield. It was probably some type of AAA-rated security, so it may have been thought of as safe. But I would never look at something to that effect."
Beth Healy can be reached at bhealy@globe.com. Steven Syre of the Globe staff contributed to this report.
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