PENSACOLA, Fla. — Discovering that their $44 million portfolio of mortgage derivatives was worth just $19 million was bad enough. But that was just the beginning: Now Escambia County’s commissioners have to decide what to do next.
The five officials already have postponed several long-planned capital improvements. For example, the budget for a road-paving program was slashed to $3.6 million from $21.2 million, a painful step in a county with so many dirt roads that one commissioner says more than 100 school buses got stuck in the mud last year. They also have hired a derivatives expert to help devise a longer-term solution.
But, paralyzed by lack of financial sophistication and by politics, the commissioners can’t seem to agree on a strategy. Moreover, Joe A. Flowers, the county’s 75-year-old comptroller who bought the derivatives, barely speaks to the commissioners; though they all have offices in the same county building here, his contacts with them are usually limited to chance encounters in the parking lot. He also boycotts their meetings and refuses to sell any of the securities.
It was different in Orange County, Calif. When it totted up its investment losses, it hired some top-flight financial advisers and lawyers. Although unable to make the losses disappear, they at least helped that county devise a strategy. But Escambia’s experience is probably more common: Many governmental bodies hit by derivatives losses don’t fully understand what went wrong, their current options or how to pursue them.
Here in Escambia, which covers 664 square miles of the Florida panhandle, the confusion is evident at a meeting of the county commission.
John Reading, the commissioner who keeps track of bogged-down buses, argues that the county should sell all its derivatives. “Let’s get out of those things, and let’s do it fast,” he says. But Tom Banjanin, like Mr. Reading a lawyer as well as a commissioner, says their value might rebound and adds: “I don’t think we should panic and dump them.” Commission Chairman Willie J. Junior, an undertaker, seems to be on the fence; he nods in agreement to both men.
Mr. Flowers, who is elected independently, isn’t present. He says he doesn’t attend the meetings because his doctor told him to avoid stressful situations. The commissioners say they learn Mr. Flowers’s views mostly from the local newspaper.
They say the rift is mainly political: Everyone fears that unloading the derivatives — securities derived from pools of home mortgages and formally known as collateralized mortgage obligations — would anger voters by turning hypothetical paper losses into real ones. If the commission forces Mr. Flowers into a sale, County Administrator Barry R. Evans says, “Mr. Flowers will say he didn’t want to sell and that the commission caused the loss.”
Orange County officials, guided by their advisers, decided to liquidate their portfolio, and Salomon Brothers Inc. did so in a few weeks. Escambia also hired a financial adviser, First Union Corp., but its role is muddled. Mr. Flowers insisted that First Union report to him because he is responsible for county finances. But because the cost of running his office is met by the investment fund’s earnings, he said he didn’t have enough money to pay First Union’s $60,000 fee. The commissioners reluctantly agreed to cover half of that amount but now complain that Mr. Flowers was slow to tell them what the Charlotte, N.C., firm advised.
Recently, the commissioners did learn that First Union recommended the sale of three mortgage derivatives purchased for some $2 million but now worth about half that. They also learned that Mr. Flowers rejected the recommendation. “I make the final decision, and I want to hold off,” he says. Some commissioners are furious; the consultants are frustrated. “We feel like we are trying to do the right thing, but we aren’t being effective,” says John Evans, a First Union executive.
As with Orange County, Escambia’s losses result from a singularly dangerous combination — risky derivatives and aggressive investing by one man.
That man, Mr. Flowers, is an old-fashioned, gregarious politician. With a bald head, a raspy voice and a bit of a stoop, he shows his age but still exudes the personal warmth of a vote-getter. His popularity stems partly from sheer longevity: He has worked in the county office building since 1946 and as the comptroller since 1960. His current term runs through 1996.
To the commissioners’ consternation, the comptroller’s reputation seems hardly blemished by the derivatives losses, helping him resist any pressure to sell the securities. Local residents still stop him on the street to offer ideas or to share a funny story. He responds with hearty clasps of their hands and shoulders.
Ironically, much of Mr. Flowers’s popularity stems from his reputation as a careful watchdog for taxpayers’ money; during his last campaign, in 1992, he played up the watchdog image by having a dog bark in the background of his radio advertisements. But financial sophistication has never been his strength.
Even his personal finances suggest limited financial skills. Records obtained from Florida’s Department of State indicate that as of year-end 1993, the most recent disclosure report available, he had just $2,825 in cash, far short of his $29,716 in credit-card balances and even larger bank loans. In 1993, he earned $78,378 from the county and got $17,178 from Social Security, but his net worth was only $17,679. He declines to explain his financial difficulties, saying, “I don’t want to talk about that.”
Actually, for most of his career, his ability to manage county funds wasn’t important. He prided himself on earning a competitive return, but there usually wasn’t much money to manage. In 1991, however, the county enacted a 1% local sales tax to fund road improvements and other capital projects, and because it didn’t expect to begin spending the revenue until this year, the money was piling up at a rate of about $20 million a year.
Eager to get high returns, Mr. Flowers was willing to listen when he began getting calls from some small Houston-based companies specializing in selling mortgage derivatives to governmental bodies around the country. The firms, the subject of a page-one article in this newspaper, have been accused in several lawsuits of misleading investors and selling securities that are too risky for public funds.
“We didn’t do business with them right away, but they kept calling and calling,” Mr. Flowers says. “They sounded like reasonable people we could trust.” Mr. Flowers says he purchased mortgage derivatives because they yielded 6% to 7% while the county’s other investments, mostly U.S. Treasury securities, were earning only about 5.5%. Eventually, he put almost half the county’s $101 million in savings into derivatives.
But the attractive yields came with probably unsuitable risks. At this newspaper’s request, Capital Market Risk Advisors, which helped Orange County with its problems, selected at random 18 mortgage derivatives in the Escambia portfolio and evaluated their riskiness. Tanya Beder, a principal at the New York firm, found all 18 extremely volatile and concluded: “This is not a portfolio that one would have if preservation of capital was the goal.”
Mr. Flowers says he never understood the risks, and he blames the dealers. “I don’t feel like they fully explained the risks that were involved,” he says, adding: “I hate to admit to being stupid, but I thought I bought mortgage-backed bonds that were backed by the government.”
Even now, his understanding of the securities seems limited. During an interview, he couldn’t recall their names and was unfamiliar with their characteristics. He also apparently didn’t know how many mortgage derivatives were in the portfolio when asked by a reporter in the wake of Orange County’s bankruptcy filing last December. At that time, Mr. Flowers said Escambia’s derivatives were purchased for about $7 million and had lost 30% of their value. He later revised both numbers sharply upward and blames his mistake on his lack of knowledge.
Even the original estimates surprised the commissioners, who say Mr. Flowers’s comments in this newspaper Dec. 8 were the first they knew of the derivatives.
Although Mr. Flowers says he is embarrassed by his ill-starred investments, he refuses to follow First Union’s advice or to relinquish any of his powers. When the commission passed an ordinance a couple of weeks ago that would prohibit him from investing in some types of securities, he quickly filed in a county circuit court here a lawsuit contending that the commission was overstepping its bounds. “They can’t put restrictions on me,” he says.
So, two months after discovering the extent of the losses, the commissioners and Mr. Flowers agree on one thing — that the derivatives are worth less than half of what they cost — but on little else.
The commissioners have spent long hours debating budget cuts. At one meeting, the financial bind is reflected in a discussion about a printing bill for less than $5,000. And discord over whether the parks or the police should bear the biggest cuts becomes heated. “We didn’t create the problem,” Mike Whitehead says, “but if the sheriff can’t buy his cars, I’m sorry.” Mr. Reading counters: “Deputies can’t walk all over the county.”
Even so, Mr. Flowers contends that the county doesn’t have a liquidity problem, noting that it appears to have enough money to fund its current budget. Although commissioners say that is true only because projects have been delayed and budgets cut, Mr. Flowers grumbles in disagreement: “I don’t know of any projects that were slowed down. They’re just not doing them.”
Ultimately, the county will have to decide whether to unload the derivatives. On one hand, a sale would lock in a loss of about $25 million. On the other, money tied up in derivatives can’t be spent on county projects. And by holding onto the derivatives, the county risks further losses.
Mr. Flowers wants to keep the derivatives because he expects interest rates to “decline toward the end of this year,” lifting the securities’ value. “I think the county will get most of its money back,” he adds. In fact, the value of most of the derivatives should return to their original level when they mature; however, the rise in rates has stretched out the maturities of some of them to more than 25 years, perhaps longer than the county can wait.
To fund the capital projects, some commissioners suggest that the county borrow against the derivatives. “They are definitely worth something as collateral,” Commissioner Whitehead says. Acknowledging that the strategy could require a long wait, he adds: “Whoever is here in 2020 will get the money — maybe our grandchildren — and they will be able to pay for new roads.” However, other commissioners worry about making the portfolio even riskier. “Borrowing is what killed Orange County,” Mr. Reading says.
In any event, outside experts challenge the wisdom of holding all the derivatives until they mature. Ms. Beder says it isn’t even clear that the county can borrow against the securities, adding: “By assuming that they can hold them to maturity, they are putting their heads in the sand.”
Spurred by some local speculation about possible wrongdoing in the derivatives purchases, a state grand jury has been empaneled, and Securities and Exchange Commission investigators are said to have visited Pensacola and requested documents. The SEC declines to comment. If investigators do uncover wrongdoing, Mr. Flowers could be forced from office. But he says he hasn’t broken any laws, and most of the commissioners are inclined to believe him. “I think he was just in over his head,” Mr. Whitehead says.
So for now, this much is certain: A big chunk of the county’s savings is gone, its 312 miles of dirt roads won’t be paved anytime soon and its ability to get out of the derivatives swamp is no greater than that of its school buses to get out of the mud without a tow truck.