Vulture investor Martin J. Whitman is positively gleeful. What misfortune is making this big-game value hunter so happy? The same event causing thousands of others so much grief: the derivatives debacle at Piper Capital Management Inc., an arm of Minneapolis-based Piper Jaffray Cos., the venerable regional brokerage. As the sharp upturn in interest rates brought huge losses to some Piper bond funds, the firm's stock plunged--and Whitman stepped in, spending about $9.5 million to amass a 6.3% stake. At an average price of $12 per share, "we got an absolute steal," he crows.
But is Whitman getting less than he bargained for? While Piper's stock has inched up after sinking to 95/8 on Oct. 7--almost half of its 52-week high of 181/2--a number of investment pros say the stock has further to fall. Fourth-quarter earnings coming out in mid-November (Piper's fiscal year ends Sept. 30), are expected to reflect the turmoil surrounding the firm. And there's a huge uncertainty in the wings: whether Piper will be held liable in lawsuits claiming that investors were misled about the nature of some of its bond funds. The Securities & Exchange Commission has made inquiries concerning information that was given to shareholders of the firm's government-bond fund.
BAD CALL. Piper's woes stem from risky bets on interest rates made by its bond-fund manager, Worth Bruntjen. Bruntjen had stocked the numerous funds he manages with complex, leveraged securities that base their value on the prepayment patterns of mortgages. When interest rates moved up, homeowners stopped refinancing and prepayments slowed. That meant that many of the securities had far longer lives than anticipated, exposing the fund to more interest-rate risk and lessening the securities' value. A number of the funds lost more than 25% of their value, or several hundreds of millions of dollars.
Whitman, however, believes the losses may be overstated. "We think the vast majority of the problem is temporary market loss and very little permanent impairment of capital," he says. "But even if it isn't, Piper is a fantastic buy," he adds, because of superior management and a solid franchise. Analyst Michael Flanagan of Lipper Analytical Securities Corp. also believes that Piper is a good long-term value for investors who are willing to weather short-term risk.
But Piper has its Cassandras. Robert Markman, president of Markman Capital Management in Minneapolis, fears that the worst may not be past for investors in Piper bond funds. If redemptions accelerate, the percentage of derivatives in the Institutional Government Income Portfolio could move higher, he says. That's because Bruntjen is likely to sell the most liquid holdings--treasuries--leaving the majority of the fund in derivatives. And if rates continue to rise, the fund could see further declines in net asset value.
FALSE ADVERTISING? Just as worrisome are the lawsuits piling up claiming the funds were misrepresented as conservative investments. True, the prospectus for the funds disclosed that derivatives could be used. But the prospectus also stated that the average life of securities was expected to be three to five years. As of mid-September, the Institutional Government Income Portfolio had a duration, or interest-rate sensitivity, of 14.6 years. (Piper would not comment on the lawsuits.) The stakes are high: If estimates of $700 million in losses are accurate, Piper's $179 million in shareholders' equity could be halved if the firm settles with investors for as little as 12 cents on the dollar.
Fans of Piper stress its long record of having one of the best returns on equity in the industry. Chief Executive Addison L. Piper points out that fiscal year 1994 looks as though it will be Piper's second-best revenue year. But Markman says 1994 numbers are irrelevant when analyzing the challenges facing Piper in 1995. His worries: Municipalities will shy away from using Piper for underwriting, institutions will look elsewhere for the management of assets, and brokers will jump ship.
There's no doubt that buying a stake in Piper involves a big gamble. But Whitman, who is investing with a five-year time horizon, remains unfazed by the challenges facing the firm. If more bad news spooks Piper's stockholders into selling, notes Whitman, all the better: "We're on the prowl for more stock," he says. The way things look, Whitman may very well get his wish.