Officials of McLennan County in Texas raised $5 million in a bond issue last year to build a zoo. As they prepared to put the money in the usual safe place until needed -- bank accounts with low but stable yields -- the telephone rang.
On the other end of the line were Houston brokers selling government securities. The county officials told the brokers that the county had two investment goals: low risk and liquidity, meaning that investments could be converted quickly to cash.
No problem, the brokers said. The county could invest in some long-term securities that would earn 2 percentage points above most bank yields and carry low risk because they were U.S. government issues. County officials signed on, putting the $5 million for the zoo in the securities and then investing an additional $8 million in them over the next few months.
Trouble was, the securities didn't meet the county's investment needs. In June, when the county needed cash and officials tried to sell the securities, they found they could do so only at a substantial loss -- about $1 million, or 8 percent on its $13 million investment.
"Sure enough, the investments were liquid -- if you didn't mind losing ... your money," said Herb Bristow, a Texas lawyer representing the county in a lawsuit against the brokers.
The trading of government instruments is a $113 billion-a-day market, the biggest securities market in the world. But compared with its counterparts that deal in corporate stocks and bonds, it is a comparatively unregulated territory permitting an increasing number of unscrupulous, high-pressure salespeople to inflict millions of dollars in losses on states and municipalities and individual investors, according to federal and state officials.
Marketing rules that govern the sale of corporate securities -- regulations designed to protect customers against unneeded trades in their accounts, excessive markups and investments that are too risky for a particular investor -- don't apply to salespeople pushing government paper.
A second problem, in additional to unregulated sales practices, is that pricing information as securities are bought and sold is all but unavailable to the general public.
As a partial remedy, federal officials generally agree that price information should be more widely available, arguing that such data would help stamp out unfair markups. Only the Securities and Exchange Commission, however, has officially endorsed mandating such a change by law. Treasury Department officials are reportedly leaning toward the SEC position, but the Federal Reserve appears willing to let private industry develop a public pricing system.
But the three agencies, the key overseers of the market for such securities, cannot agree on ways to tighten controls over sales practices without imposing overly burdensome red tape on brokers and dealers that could increase the government's cost of raising money.
Lured by the image of safety associated with government securities, municipal and state officials have often purchased such instruments confident that they were making low-risk, even risk-free, investments.
Fifteen or 20 years ago, when government securities were plain vanilla items like Treasury bonds, that was a reasonable assumption. But the 1970s and 1980s spawned a whole range of interest rate-sensitive, high-risk offshoots of government securities -- the so-called derivative instruments that increas-ingly take on the characteristics of private-sector securities.
In addition to straightforward bonds, the government securities market now includes a universe of complicated spinoffs on mortgage-backed securities, repurchase and reverse-repurchase agreements, zero-coupon bonds and a host of other relatively risky instruments.
These instruments often offer higher returns than the plain vanilla Treasuries, but their market value can be highly vulnerable to swings in interest rates.
While federal and state officials generally agree that most government securities dealers and brokers are honest, the growth of the new derivative instruments has attracted unethical brokers known as "bond daddies."
These salespeople, out for a fast buck, "are the flashy, diamond-ring-on-the-finger, churn 'em and burn 'em guys," said Martin Aussenbert, a Tennessee lawyer who represents the Memphis Housing Authority and the City of West Palm Beach in Florida in civil suits against government securities brokers similar to the one filed by McLennan County.
Statistics on the growth of unfair practices are hard to come by. The General Accounting Office, the investigative arm of Congress, issued a report last month recommending that Congress pass a law requiring wider dissemination of price information and adopt sales rules similar to those governing the corporate securities markets. But, as the government securities industry points out, the report lacked any statistical data on the prevalence of unscrupulous practices.
The Public Securities Association, which represents government securities dealers, has argued against the enactment of sales practice regulations until more information can be obtained from the SEC on who commits the abuses, where and with what frequency. So far, the PSA argues, the evidence has been only "anecdotal" and, as such, insufficient to justify a barrage of new sales rules.
"The word anecdotal seems to belittle the incidence of loss that has occurred over the last several years," said Michelle Saddler, manager of Government Finance Officers Association, which represents more than 12,000 state and local government finance officers.
"Millions of dollars have been lost over the last few years due in part to the sales practices of government brokers and dealers. Any loss of public funds is too much," Saddler said.
The House subcommittee on telecommunications and finance has asked the SEC to supply numbers on unfair practices by the end of the week. But, according to evidence gathered so far by state and federal officials, the trend is upward. They say that the problem is not in the primary market -- the small group of 40 government-authorized dealers who buy securities directly from the government -- but in the secondary market, where thousands of dealers and brokers buy and sell existing securities.
Officials worry that as the SEC cracks down on some areas of securities abuse like penny stock fraud, the fast talkers will merely move into other relatively unregulated markets.
"The recent focus on the problems of penny stocks raises concerns that the scam artists so prevalent in that market may seek next to move into the market for government securities, which has traditionally been far less regulated than the corporate securities markets," subcommittee Chairman Edward J. Markey (D-Mass.) and subcommittee member Rep. Jim Cooper (D-Tenn.) wrote in a letter to the SEC last month.
"Throughout the country, we have learned of grossly inflated pricing markups, high-pressure telephone sales with scripted sales pitches, churning of accounts and the sale of wholly unsuitable investments to government securities investors," they wrote. "Public confidence in the integrity of the government securities market is essential to the ability of the federal government to sell its securities at the lowest cost."
After the collapse of several major securities dealers in the past decade, including one that triggered a savings and loan crisis in Ohio, Congress passed the Government Securities Act of 1986. The law imposed more federal oversight on securities dealers, primarily through stricter funding and bookkeeping requirements. But the law specifically exempted government securities dealers from being subject to rules that apply to corporate securities transactions.
The result is that customers who lose money can successfully sue government securities brokers only if they can establish fraud had been committed, a standard that is much harder to prove than violations of securities rules. Congress is now considering whether to toughen the law.