Could Spur U.S. Regulation : Far-Reaching Effects Seen in ESM Collapse

The collapse last week of ESM Government Securities Inc. is not the first debacle in the risky, largely unregulated world of government securities trading. But it may be the biggest and most far-reaching.

It could also finally lead to federal regulation of government securities trading, an industry deeply shaken three years ago by the collapse of Drysdale Government Securities, which in turn led to losses of $285 million at New York’s giant Chase Manhattan Bank.

Already, the collapse of Fort Lauderdale, Fla.-based ESM has led to the failure of Cincinnati-based Home State Savings Bank. The panic that inspired in depositors led Ohio Gov. Richard F. Celeste to order 70 other thrifts in the state to close temporarily to prevent a run on deposits. That is believed to be the first government-imposed shutdown of financial institutions to avoid a deposit run since the Depression.

Heavy Losses Possible

Dozens of other financial institutions, municipalities and individual investors that dealt with ESM stand to lose as much as $320 million. The full extent of the losses may not be known for months as lawyers, accountants and others work to unravel a web of complex transactions. Customers are expected to file a torrent of lawsuits to recover whatever they can.

Initial findings by the Securities and Exchange Commission--which shut down ESM on March 4--and other investigators reveal at least some understanding of how ESM was able to deceive so many of its customers. According to the SEC, this is the way events unfolded:

Formed in 1976 by government-securities traders Ron Ewton, George G. Mead and Robert Seneca, ESM played a high-stakes, fast-moving game in which traders can make, or lose, millions of dollars in a very short time.

At the center of the ESM scandal were complex financial transactions known as repurchase agreements, or “repos.”

Higher Rate of Return

Under these deals, municipalities, financial institutions and other customers would lend ESM cash in exchange for an equivalent amount of government securities as collateral. ESM would then agree to buy the securities back on a later date at a higher price, giving the customers a rate of return on their cash higher than they would have received by keeping the money in checking accounts or other lower-yielding instruments.

ESM in turn tried to make a profit by investing the customers’ cash in investments that would yield even more than ESM paid to the customers.

ESM also engaged in reverse repurchase agreements, opposite transactions in which it loaned cash and took securities as collateral.

However, investigators say, ESM made a profit only in its first year. After that, for reasons still unclear, it lost millions, including more than $200 million in the last six years.

Yet all the time ESM was losing money, its executives paid themselves lavish salaries and bonuses and took out millions of dollars in loans from the company--in effect, looting it.

The firm managed to conceal its losses from customers largely by transferring the deficits to its parent company, ESM Group Inc.

Such losses, however, still should have wiped ESM out. But the firm managed to stay in business by pledging its securities to more than one customer. Thus, it was able to obtain cash from several customers using the same securities.

It got away with this largely because many less-sophisticated customers never asked for physical delivery of the securities before giving ESM their money. Instead, they trusted ESM to hold the securities on deposit, making it easy for ESM to reuse them as collateral for other loans.

One of the largest ESM customers was Home State Savings. Its owner, Marvin L. Warner, is a savvy deal maker and Democratic Party fund-raiser who became a close friend of ESM co-founder Ewton.

Home State had lent ESM securities in exchange for $670 million in loans. Meanwhile, Warner had steered other entities to ESM, including American Savings & Loan of Florida, of which Warner at the time owned 25%.

The situation at ESM began to unravel in late 1984 when American Savings became suspicious of its dealings with ESM and asked for its securities back. ESM could only return a fraction of them.

Other ESM customers began to worry. Finally, on March 4, the SEC was called in. ESM was closed that day and put into receivership. Home State Savings failed the following Saturday as depositors, worried by the Cincinnati institution’s involvement with ESM, withdrew $90 million.

The principals in the case were either unavailable for comment or declined to comment through their attorneys.

One of the biggest losers besides Home State is American Savings, which has estimated its loss at $55.3 million. At least 50 other entities could lose some or all of their investments, including the cities of Tulsa, Okla.; Toledo, Ohio; Pompano Beach, Fla.; Beaumont, Tex., and Memphis, Tenn., and Clark County, Nev.