EAI falls victim to derivatives market

Education Alternatives Inc., which manages schools in pTC Baltimore and Hartford, Conn., got a painful economics lesson in recent months, as the value of its $36 million investment in derivatives and securities has dropped by more than one-third.

Corporate finance specialists and a national teachers union criticized EAI yesterday for investing in derivatives -- volatile, interest-sensitive investments that have cost companies and communities around the nation billions of dollars as interest rates have risen. Orange County, Calif., for example, has filed for bankruptcy protection after a $2 billion loss from investments in derivatives and other securities.


"This is insanity," William A. Sahlmon, professor of entrepreneurial finance at Harvard Business School, said, adding that companies should buy only short-term, conservative investments with their cash. He criticized EAI's investments in .. long-term derivatives, complex investments whose value "derives" from more simple underlying investments, such as mortgages or Treasury notes.

But EAI officials defended the move, saying it would not affect the company's financial stability or operations.


EAI has plenty of cash to operate its schools, and the investments -- in Treasury notes and mortgage-backed derivatives -- eventually will bring EAI between 7 percent and 8 percent on its investments, said EAI Chairman John T. Golle.

"What are we supposed to do, put [our money] in a shoe box?" Mr. Golle asked. "Tell me what's safer, will you please? These are U.S. Treasury notes and securities backed by mortgages on people's homes."

He said, "In retrospect, looking into a crystal ball, maybe we shouldn't have [made the investments] because of the decline of the market value." He added, "We do not own the exotic derivatives like Orange County."

Mayor Kurt L. Schmoke said he was unaware of EAI's investments in the securities and the resulting paper losses. Because of the risks, the mayor said, the city has opted for more conservative investments, but he said he had no reason to believe EAI's losses would result in cutbacks to Baltimore


"We know from the Orange County experience that businesses investing in the derivatives market can be a risky venture," Mr. Schmoke said. "My concern about EAI's financial condition is simply whether they have the resources to carry out commitments they made to our school system. . . . So far, it doesn't make me nervous."

Minneapolis-based EAI, which holds more than $180 million in city contracts, began managing nine schools here in 1992 and has since begun working in three others. This fall, Hartford signed a five-year, $1 billion contract giving EAI control of its entire school system.

The money that EAI placed in interest-rate sensitive investments came mainly from an April 1993 stock offering that raised $31.2 million for the school management firm. The company also invested cash earned from its contracts managing schools in Baltimore and other cities, said EAI controller Tony Verbeten.


The company invested nearly $32 million in U.S. Treasury notes and mortgage-backed securities issued by federal agencies such as the Federal National Mortgage Association, known as Fannie Mae.

And the company put $2.2 million into a Piper Jaffray mutual fund that has lost about a third of its value because of investments in bonds and derivatives whose value fell as interest rates increased.

EAI also invested several million dollars in mortgage-backed securities, including some derivatives known as "inverse floaters."

In one case, for example, the company put nearly $700,000 into a derivative packaged by Prudential Home Mortgage Securities Co. That derivative, backed by 20-year home mortgages, promised to pay higher profits whenever interest rates fell. As interest rates rose, the value of the investment has fallen. As of Sept. 30, the investment was worth only $449,000, EAI reported.

From mid-1993 to September of this year, the value of the invested reserves fell by more than $13 million, according to corporate filings with the Securities and Exchange Commission. And stock analysts said this week that because of rising interest rates, EAI's investments had probably fallen several more million dollars in the last several weeks.

Mr. Verbeten said yesterday that he is not worried about today's low market prices. Instead, he said, EAI plans to hold the securities until they mature -- in some cases, as late as 2013 -- when the securities are expected to return all of their principal.


Dr. Sahlmon, the Harvard professor, discounted the company's claim that since it has not sold the securities, it is only suffering a "paper" loss.

EAI "had an economic loss, period, end of paragraph. They just took $13 million and flushed it away. That is not acceptable," he said.

The 450,000-member American Federation of Teachers, a consistent critic of EAI, questioned whether the company should have undertaken such risky investments when it holds tens of millions of dollars in public funds.

"I think it's clear that is a business that engages in very risky practices," said F. Howard Nelson, an AFT researcher.