The spark that ignited the collapse of Cincinnati-based Home State Savings Bank and the subsequent crisis involving Ohio's other privately insured savings and loans was the fall of a Fort Lauderdale, Fla.-based firm, E.S.M. Government Securities Inc..
The link between the collapse of E.S.M. and the problems in Ohio was created by the extensive dealings between Home State Savings Bank and E.S.M. Home State lost an estimated $100 million when E.S.M., which was engaged in buying and selling government securities, collapsed.
The less obvious relationship between E.S.M. and Home State appears to be through Marvin L. Warner, the influential Democrat who served as ambassador to Switzerland under President Carter. Warner controlled Home State and two other S&Ls that regularly dealt with E.S.M.
Court records show that Warner was one of a small group of individuals who had a personal account with E.S.M., which dealt mainly with large institutions.
Warner's son-in-law, Miami attorney Stephen Arky, was friends with one of E.S.M.'s founders, Ronald Ewton.
The failure of E.S.M. has raised anew concern over the lack of regulation of government securities transactions that are the staple of such firms.
The issue arose when Drysdale Government Securities Inc. collapsed in 1982, sending similar shock waves through the government securities market and leaving several banks with big losses.
E.S.M., which has not made a profit since 1977, apparently hid its losses by keeping several sets of books.
Instead of showing losses on the books examined by its auditor, Alexander Grant & Co., ESM apparently transferred its losses to a parent company's books.
The scheme continued to work even though the group of E.S.M. companies was losing money, as long as new cash flowed in to finance the losses.
But it appears that as soon as some financial institutions stopped doing business with E.S.M., the firm went under, because it was unable to stop bleeding and unable to raise new funds.
The funds that S&Ls and municipalities advanced E.S.M. apparently were in the form of unsecured loans, though the lenders may not have known that.
Transactions called repurchase agreements and reverse repurchase agreements were used in most cases.
Under repurchase agreements, an S&L would agree to purchase securities from E.S.M., which E.S.M. would agree to buy back at some future date. E.S.M. would get cash from the S&L and the S&L would get the securities as collateral.
In reverse repurchase agreements, an S&L would use government securities as collateral for a loan from E.S.M. It then would use the loan as a down payment to purchase additional securities, or it would invest the money elsewhere.
Problems arose when securities held by E.S.M. for S&Ls apparently were pledged as collateral for multiple loans.
For example, when American Savings and Loan of Miami asked E.S.M. to give it the securities it was holding for American, E.S.M. did not have them, presumably because they had been pledged as collateral elsewhere.
Despite Alexander Grant's failure to detect the scheme for several years, it reportedly took court-appointed investigators examining E.S.M.'s books less than an hour to discover the losses.
E.S.M. was closed by the Securities and Exchange Commission, which alleged that the firm engaged in fraudulent activities.
In addition to Home State, several municipalities, including Beaumont, Tex., and Toledo, also may suffer losses.