WALLINGFORD, Conn. - The Department of Labor is suing trustees of the $105 million Connecticut Plumbers and Pipefitters pension fund over alleged losses of at least $3 million in mortgage-backed securities.
The suit, filed in U.S. District Court in Connecticut, alleges trustees authorized the purchase of "overly risky" classes of collateralized mortgage obligations, such as inverse floaters and interest-only strips. Inverse floaters and IOs are mortgage-backed securities that generally represent a bet that interest rates will fall. They can lose value quickly if interest rates rise.
The lawsuit is the Labor Department's first involving exotic mortgage-backed derivative securities.
Among the Labor Department's allegations are that trustees:
Authorized purchases and sales of "overly risky" mortgage-backed securities, of which they had an inadequate understanding;
Improperly delegated complete discretion in setting the timing and price of the purchases and sales of the securities to a broker, Steven G. Hassenmiller, who also is named as a defendant;
Never made Mr. Hassenmiller comply with the fund's requirements for investment managers;
Ignored the advice of their independent adviser - at that time Segal Advisors Inc., New York; and
Failed to effectively monitor the fund's mortgage-backed securities investments.
Frank Krzywicki, a trustee and manager for the fund named as a defendant, did not return repeated phone calls. Other trustees named in the suit either could not be reached or did not return phone calls.
Ted Scallet, partner in the Washington office of LeBoeuf, Lamb, Greene, and McRae, who represents the trustees, said trustees have yet to be served papers on the suit. He said the trustees will have no response until they get a chance to look a the suit.
Paul Ondrasik, a lawyer for Mr. Hassenmiller, declined comment.
Michael Schloss, a trial attorney in the office of the solicitor at the Labor Department, said the trustees "had no clue" as to what they were buying through Mr. Hassenmiller. Some of the securities were highly leveraged, with one of the IO securities leveraged six times, he said.
Mr. Schloss said the relationship with Mr. Hassenmiller resulted from cold calling Mr. Hassenmiller had done. The mortgage-backed securities were offered to the pension fund as securities that provided liquidity and high yield.
Trustees began purchasing securities through Mr. Hassenmiller in 1988, and continued to buy and sell through February 1994, the suit alleges.
Mr. Hassenmiller's employers for transactions covered by the suit included PaineWebber Inc., New York, and two Houston firms, Westcap Government Securities and Arbour Financial Corp., according to a Labor Department statement. Westcap is in bankruptcy; Arbour is now called Amherst Securities Group.
In July 1989, the Plumbers and Pipefitters fund's consultant, Segal Advisors, recommended the trustees hire investment managers for the mortgage-backed securities bought in 1988, but no action was taken, the suit says.
In 1990, Segal responded negatively in a written report to proposals to buy so-called Z tranches of CMOs, a volatile class of mortgage-backeds, the suit says. Mr. Schloss said trustees didn't buy the Z-tranche securities, and, in a written response, Mr. Hassenmiller outlined part of his role with the fund.
Mr. Hassenmiller wrote to the trustees that active management of the MBS portfolio was not necessary because "your current investments are monitored daily by me," according to the suit.
A spokeswoman for Segal said the consultant that worked on the Plumbers and Pipefitters account, Phil Dellocono, no longer is with Segal Advisors. (Segal Co. is still an actuary for the fund.)
Mr. Dellocono, now a first vice president in the New York office of Investment Performance Services Inc., Savannah, Ga., declined comment.
Mr. Schloss said Mr. Hassenmiller and the trustees made money for the fund up until 1993 and early 1994, when big losses began to mount and bond prices ended a tremendous bull run.
Other MBS investors, such as hedge fund manager David Askin and the securities lending unit of Harris Trust & Savings Bank, Chicago, also were burned with overly bullish strategies.
The Labor Department's suit said that by April 1994, fund trustees hired Criterion Investment Management, Houston (now a part of Nicholas-Applegate Capital Management, San Diego) to take over the portfolio.
Criterion said the fund's MBS portfolio was "improperly volatile" and advised shifting the fund out of its holdings into longer maturity securities, the suit says.
A spokesman for Nicholas-Applegate declined to comment.
Mr. Schloss said the Connecticut Plumbers and Pipefitters generally had $16 million to $21 million of its fund invested through Mr. Hassenmiller in the two years leading up to the losses.
By June 1994, all of the mortgage-backeds bought through Mr. Hassenmiller were sold, at a total loss of $5.5 million, according to the suit.
The exact dollar amount is unclear because of the expiration of statutes of limitations on certain transactions and because the courts will determine if the trustees can net previous gains in securities against losses, Mr. Schloss said.
The Labor Department's position is that the gains cannot be netted, he said. Mr. Schloss says total losses are between $3 million and $5.5 million, with the Labor Department seeking the losses plus opportunity costs.
ERISA attorney David Levin, managing partner with Reish & Luftman, Washington, said what's most notable about the Labor Department's suit is that it doesn't say investment in derivatives is a breach of duty.
"I was delighted to see it didn't say that," Mr. Levin said. The suit provides a level of comfort for those worried the DOL might take an overly strict stand on derivatives usage.
"If you take out the word derivatives, (the suit) sounds exactly like a run-of-the-mill breach of fiduciary duty case," Mr. Levin said.
More CMO-linked suits could follow. Mr. Schloss said the Labor Department has a number of investigations into pension fund investments in CMO derivatives.
