Just over a month ago, Philip Luhmann was just another obscure bureaucrat. At City Colleges of Chicago, where he was entering his 21st year as treasurer, he was known as a quiet, competent man who didn’t stand out in a crowd.
“He could blend into a wall,” said one associate.
Not anymore. Today, Luhmann is center stage in an investment fiasco that has cast a cloud over the finances of City Colleges, the nation’s second-biggest community college system with 44,000 full-time students at seven institutions.
The problem surfaced in early February, when Luhmann acknowledged to City Colleges officials that he had made a mistake.
Luhmann isn’t talking publicly about what happened. But according to City Colleges authorities, he placed nearly the entire portfolio of more than $100 million into mortgage securities.
The investments weren’t ordinary mortgage bonds, but a complex breed of securities whose price fluctuates wildly in response to swings in interest rates. As rates rose in the last few months, the value of the securities plummeted.
For now, City Colleges hasn’t sold the securities, so the loss is a projection. “Very clearly, we have lost significant amounts of money on these securities on paper,” said Ronald Gidwitz, City Colleges chairman.
Luhmann was fired from his $79,000-a-year job on Feb. 25, when the debacle was disclosed. City Colleges said he breached its investment policy by buying interest-rate sensitive securities that could not be converted to cash without a sizable loss, and later made an unauthorized loan to cover the resulting cash squeeze. The system has asked the U.S. attorney to investigate Luhmann’s transactions.
There have been bigger cases where mortgage-security investments by public bodies have raised questions in the last few years. But the Chicago episode has attracted national attention-and may be particularly devastating-because so much of the college system’s portfolio is tied up in the bonds.
“To have no diversification in a portfolio is just crazy,” said Jeff Spies, treasurer of St. Petersburg, Fla. “It’s the No. 1 rule.”
The questionable investments have not only plunged City Colleges into a financial morass, but have also enmeshed it in a nasty tussle with Westcap Securities, the Houston company that sold the bonds. The college system has threatened to sue Westcap to recover its original investment.
The incident has raised troubling questions. In the case of City Colleges, how did Luhmann come to have virtually free rein over the portfolio? For its part, did Westcap have a duty to protect a public entity from making such a big investment in highly volatile securities?
But the chief mystery involves Luhmann himself. Why would a man regarded as cautious to a fault by colleagues and friends apparently bet the farm that interest rates wouldn’t rise?
“The real issue here is this guy decided to make a bet-not an investment, but a bet,” said Elisa Herr, managing editor of Mortgage-Backed Securities Letter, a New York-based trade publication that focuses on these types of financial instruments.
Such a gamble could hardly seem more out of character. Those who know him view Luhmann as the epitome of financial conservatism.
“I hate to use the nasty stereotype of the bean counter with green eye shades, but that was Phil. I don’t think he ever wrote down a column of numbers where he didn’t add it up five times,” said a former City Colleges co-worker.
Luhmann, 61, is a classical music lover with deep roots in Chicago’s university community of Hyde Park, where he grew up and still lives.
He is a lifelong member of the First Presbyterian Church in nearby Woodlawn and was the church’s unpaid bookkeeper for at least 15 years before stepping down last fall. Luhmann has also been treasurer of the cooperative association for the modest townhouse complex where he and his wife raised two daughters.
Luhmann’s friends don’t believe he intentionally did anything wrong. “Anything he might have done was to enhance the position of the colleges,” said Rev. Gerald Wise, pastor at First Presbyterian. “They don’t come straighter than this guy. There is no secret side of this guy.”
Luhmann, with crew cut and spectacles, politely declined to talk to a reporter who rang his doorbell. His lawyer, Matthew Piers, said Luhmann has asked City Colleges for a hearing to reconsider his firing.
Officials at City Colleges apparently had allowed Luhmann great discretion in handling investments. Treasurer since 1973, Luhmann got his doctorate in education from the University of Illinois. He joined City Colleges in 1966.
When Mayor Richard Daley named Ronald Gidwitz City College’s chairman in fall 1991, Luhmann seemed so capable that Gidwitz decided investments weren’t a problem area. He turned his attention to more pressing concerns, like ousting controversial former chancellor Nelvia Brady and cutting low-demand classes.
For most of his tenure, Luhmann’s investment strategy was conservative. Illinois law limits the kinds of investments community colleges can make.
Most institutions stick to safe, short-term instruments such as U.S. Treasury bills and notes, bank certificates of deposit and an investment pool run by the state treasurer.
But in the last few years he surprised some salesmen at local bond firms by favoring increasingly volatile mortgage securities.
Mortgage instruments are created when federal agencies buy mortgages from lenders, pool them and guarantee bonds whose payments depend on homeowners’ monthly mortgage payments. The main risk for investors is that no one can predict when the mortgages will be paid off-when interest rates fall, homeowners tend to refinance, but when rates rise, they hold onto their old mortgages.
Mortgage securities have become increasingly complex in the last 10 years, as Wall Street wizards began carving out various cash flows from mortgage pools. Some of the new instruments carry more predictable payments, but others are volatile.
Just when Luhmann began experimenting with risky mortgage securities is unclear. His reports to City Colleges’ Finance Committee show 62 percent of the system’s $110.2 million portfolio in mortgage securities in November 1992.
But none of his recent reports provide details on the kinds of mortgage securities he bought. The only breakdown is between Government National Mortgage Association securities ($14.7 million in November 1992), a fairly common community college investment, and “other agency mortgage-backed securities” ($53.5 million).
Former City Colleges employees recall little talk about mortgage securities at Finance Committee meetings. Trustee discussions of investments dwelled mainly on which banks should hold the system’s deposits, these sources said.
As treasurer, Luhmann reported to the trustees. And even if he had wanted to consult the system’s chief financial officer, after mid-1992 the post was vacant until Leonard Sippel was hired last November.
When short-term interest rates were low, Luhmann’s investment returns outstripped those at other Chicago-area community colleges. For the fiscal year ended June 30, 1993, City Colleges earned 9.4 percent on its investments, compared with 6.3 percent at Oakton Community College.
Oakton, in Des Plaines, itself ranked well above 12 other local community colleges in a survey of returns for February 1993, because it had longer-term investments. Roger Kempa, treasurer at Morton College in Cicero, who conducted the survey, said Luhmann was the only college official who declined to participate.
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“He said he wanted to keep his investments private,” Kempa said. “He didn’t want to publicize what he was doing there.”
Last October, Luhmann bought from Westcap about $96 million in a brand of mortgage securities based on principal-only bonds. Returns on these so-called POs come from principal payments on a group of mortgages. When interest rates are low and many homeowners refinance mortgages, POs have high returns and pay off quickly. But when rates rise and homeowners hang onto their mortgages, returns fall.
The securities in question weren’t just ordinary POs, but part of a Federal National Mortgage Association (or Fannie Mae) issue in which returns from POs were divided into classes, some of which get paid before others.
The bulk of City Colleges’s investment was in a “super PO”, which gets no return at all if refinancings fall off. A Fannie Mae prospectus shows the yield on those securities varying from 0.9 percent to 19.5 percent, depending on refinancings. Similarly, the maturity could range from 1.2 years to more than 28 years.
For the last two years, low interest rates have made POs star performers. Last September, many experts continued to predict that rates would remain low and refinancings plentiful.
But rates began to reverse course in mid-October, rising sharply since and hurting refinancings. In November Luhmann, pressed for cash, engaged in what is known as a reverse repurchase agreement with Westcap.
Luhmann sold about $34 million of the securities back to Westcap with an agreement to buy them back at a later date, effectively borrowing money from the Houston firm, said City Colleges. The agreement was extended twice, in December and January.
City Colleges insists it was in the dark about all of this until early February. Four times a year, Luhmann presented a status report of the investments usually pegged to a date about five weeks earlier.
But in January Luhmann’s report was based on Sept. 30-13 weeks earlier and before he invested with Westcap.
That report showed about a third of the portfolio was invested in various mortgage securities.
“There were problems with the September report, which is why it was late, one might assume,” said Gidwitz. “If in fact it were later than usual, we didn’t realize at the Finance Committee meeting at the time it was as late as it was.”
He attributed the lapse to a spate of management changes, including the arrivals of a new chancellor and chief financial officer. “I think it’s reasonable to assume there was disruption in some of the routine.”
People began to pay attention on Thursday, Feb. 3., however.
That’s when, after a regular board meeting, Luhmann walked into Sippel’s office and said simply, “I made a mistake,” according to Sippel.
What prompted the admission? Luhmann had agreed to buy other mortgage securities from Prudential Securities Inc. and didn’t have the money to honor the commitment, Gidwitz said. Prudential has since paid City Colleges $3.05 million to cover any losses on the transaction.
Luhmann’s revelation didn’t trigger alarm at first. Gidwitz, president of toiletries maker Helene Curtis Industries Inc., said it just seemed like a temporary cash shortage. So, on Saturday, he left for Europe on business, confident a bank loan would solve the problem.
But banks that scrutinized the portfolio scoffed at the collateral, Sippel said. Sources close to City Colleges said the value of the Westcap securities has dropped 30 percent since the system bought them.
The super POs portion of that portfolio is down about 50 percent, according to mortgage market sources.
At his hotel, Gidwitz was awakened midnight Monday, Feb. 7, by an urgent phone call from Chicago. Chancellor Ronald Temple told him of the system’s financial crisis.
Gidwitz flew home the next day and by Wednesday had organized a team to investigate. First National Bank of Chicago later lent City Colleges the money to repay the Westcap loan.
In the wake of the incident, City Colleges has changed its rules. The treasurer now reports to the chancellor; an outside investment adviser is being sought.
City Colleges is pressing Westcap to rescind the trades. “It’s our position that Westcap knew of our investment policy just as Phil Luhmann knew of our investment policy and there’s shared responsibility,” said Jacqueline Woods, vice chancellor for external affairs.
Tom Pollard, Westcap executive vice president, said the company did not have a copy of the guidelines and he isn’t sure whether its salesmen were aware of them.
He said the company has not determined whether salesmen went far enough to determine the suitability of Luhmann’s investments. “Know-your-customer” rules haven’t traditionally applied to government securities, though the National Association of Securities Dealers is currently drawing up such rules.
Westcap, a unit of National Western Life Insurance Co. in Austin, Texas, said it has a City Colleges document authorizing business dealings with Westcap as of April 1993. It is signed by the board’s assistant secretary, Patricia Buck, and includes Luhmann’s signature card, according to Westcap, which declined to provide a copy.
City Colleges contends there was no such board authorization.
Pollard said Westcap salesmen did not get answers from Luhmann about his other investments. He declined to say how much money Westcap made on its City Colleges deals.
Meanwhile, the Illinois Community College Board, which oversees the state’s two-year institutions of higher education, has asked its lawyers to determine whether City Colleges violated state law.
Though Illinois law permits local governments to invest in obligations of federal agencies, it is not clear whether Fannie Mae is an agency under state law.
The board could withdraw City Colleges’ accreditation, meaning it would lose the third of its $256 million budget that comes from the state.
City Colleges officials believe that outcome is unlikely.
Carey Israel, executive director at the Illinois Community College Board, said City Colleges will have no trouble paying its bills for the next month or two. But “there could be some hindrance several months from now depending on the outcome of any contemplated litigation or findings,” he said. “It becomes a cash-flow question.”