$1 million is lost in deal backed by risky loans

The city of St. Paul has written off a $1 million investment that it says it was misled into buying by its broker in August, the city attorney and treasurer said Friday. The city is expected to hire an outside attorney to try to recover the money.

Merrill Lynch, which has purchased millions of dollars of investments for the city over several decades, disputes the claim, saying a St. Paul cash manager initiated the deal.

"We're surprised," said Merrill Lynch spokesman Bill Halldin.

What the city thought was a highly rated short-term investment known as commercial paper turned out to be a risky security backed in part by subprime mortgages, city officials said. The name of the paper is Golden Key, which at the time of the investment was a $5 billion program.

St. Paul is joining a growing list of municipalities, institutions and agencies trying to recoup losses as the subprime mortgage meltdown continues to rock financial markets. Cities in Iowa and Indiana have sued brokers for selling them investments not allowed by governments because they are too risky.

The St. Paul Port Authority will go to arbitration with Wells Fargo over a $500,000 Golden Key investment made last year that the agency claims was unauthorized. Wells Fargo says the claims are without merit.

On Tuesday, the City Council is expected to approve hiring of Mark Briol, a Minneapolis business litigation attorney and securities arbitration expert, to try to retrieve its money. He would work on a contingency basis.

City Attorney John Choi said no definite decision has been made on whether to sue.

"It is our position that Merrill Lynch owed us a fiduciary duty as our hired financial adviser in this transaction. Our financial adviser should not have sold us an investment that violated state law and the city's investment policy," Choi said. "In many ways we were misled in this transaction, and the city will aggressively take every possible legal action to recover the public's money."

But the transaction did comply with the city's investment policy and state law, Halldin said.

"The investment itself was brought to us by the city, and we were asked to execute the transaction," he said. "It's similar to other investments the city had purchased."

In this case, the city bought $1 million of Golden Key commercial paper, which at the time of sale had the highest ratings by Moody's and Standard and Poor's. Two weeks after the Aug. 7, 2007, purchase, Golden Key was downgraded, a so-called "enforcement action" occurred and the Golden Key assets were frozen.

The amount is a small fraction of the city's $250 million investment portfolio. At the time, said City Treasurer Todd Hurley, about 20 percent of the portfolio was in commercial paper -- short-term promissory notes issued primarily by corporations.

The city filed a report on its investment with the Securities and Exchange Commission in March after being contacted by the agency. The SEC said it had opened an investigation into Merrill Lynch's handling of subprime mortgage portfolios, Hurley said.

The city no longer buys commercial paper, he said, and it has stopped working with Merrill Lynch.

Commercial paper is one of several investment types approved under Minnesota statute 118A, which was designed to make sure public money is put into secure investments. Keeping the principal amount safe is generally the top priority of a municipality, said Kathleen Aho, president of Springsted, a public finance adviser.

"It's unusual to find a situation where there's a loss," Aho said.