Case Study

The top securities regulator in Massachusetts accused Merrill Lynch on Friday of defrauding the city of Springfield with subprime-linked investments, casting light on how Wall Street banks sold complex mortgage securities that are now plummeting in value as the housing slump deepens.

William Galvin, the Massachusetts secretary of state, filed a civil fraud complaint against Merrill a day after the firm took the unusual step of agreeing to reimburse Springfield for losses on the investments. Merrill agreed to buy back the securities at their original value, $13.9 million, after determining that its brokers had not been authorized by Springfield to buy the securities on the city’s behalf.

“They are alleging fraud against a municipality, which carries with it much more gravitas than a simple lawsuit,” Mark A. Flessner, a partner at Sonnenschein Nath & Rosenthal in Chicago, said of the complaint. An official in Mr. Galvin’s office said the Springfield case was part of a larger investigation into Merrill’s sales of similar investments to other Massachusetts towns and cities.

Asked about the Springfield case, Mark Herr, a spokesman for Merrill Lynch, said, “We are puzzled by this suit.” He declined to comment on the broader investigation.

The case underscores how subprime investments keep turning up in unexpected places and raises new questions about Wall Street’s sales practices and its role in the mortgage crisis. In recent years, as home prices soared and mortgage lending boomed, investment banks packaged hundreds of billions of dollars of home loans into securities for sale to investors around the world. Now, record defaults are resulting in huge losses for municipalities, states, banks, insurance companies and nonprofit organizations.

Wall Street banks have lost billions of dollars of such investments themselves. Merrill has been one of the hardest hit, writing down almost than $25 billion, the bulk of which came from mortgage-related securities.

But banks rarely reimburse clients for losses, because doing so might prompt others to demand refunds when their investments sour. Merrill Lynch officials, however, said the Springfield case was unusual because the central issue was the firm’s sales practices, not whether the city was a suitable buyer for the securities.

The deal between Merrill and the city was brokered on Thursday by the state’s attorney general, Martha Coakley, along with the Springfield Finance Control Board and representatives from the city of Springfield. But Mr. Galvin, in his complaint, argued that the city had not been properly warned of the risks associated with the investments. By the end of 2007, the $13.9 million of securities were worth $1.2 million.

“We are trying, through this complaint, to address the systematic supervisory breakdown that allowed these sales to be made,” said Brian Lantagne, director of the Massachusetts securities division.

According to the suit, Manuel Choy and Carl J. Kipper, two Merrill brokers hired by the Springfield Finance Control Board, were told to pick “instruments that yielded more than Merrill’s money market account as long as the products were triple-A rated by the major credit-rating agencies.”

The pair invested about $14 million of the city’s newfound budget surplus into three so-called collateralized debt obligations — pools of debt securities that were backed by residential mortgage-backed securities and commercial-backed securities (which in turn are pools of residential and commercial mortgage loans). Some of the debt obligations were backed by other debt obligations and synthetic securities, securities backed by derivatives, the suit says.

But the suit says the brokers did not communicate to the city that they had invested the city’s money in collateralized debt obligations, never explained the risks of the investments and never produced the documents laying out certain risk factors.

What Merrill did deliver to Springfield was a presentation entitled “Merrill’s Auction Rate Market Sheet” that set out to explain the market for short-term securities aimed to help sophisticated investors manage cash.

According to the sheet, the securities represented a “large and liquid market” with “high-quality credits” and similar returns to other short-term instruments like commercial paper and money funds. The presentation specified that 92 percent of the securities in which Merrill participated were triple-A rated and 97 percent were double-A rated.

Last summer, when the market for collateralized debt obligations backed by subprime markets seized up, the value of Springfield’s securities plummeted. For example, Mr. Choy and Mr. Kipper invested $12.6 million in April 2007 into the “Centre Square C.D.O.” By August that C.D.O. had a value of 84 percent of its purchase price; by September it was down to 50; in October, 30 percent, and by December, only 5 percent. When the city asked that Merrill sell the securities, Merrill said there were no buyers.

Mr. Kipper, reached at home, declined to comment. Mr. Choy did not return a call for comment.

After the city complained to Merrill about the products, James Mann, the firm’s general counsel, responded in a letter, “While Merrill Lynch is disappointed with the unfortunate disappearance off liquidity in the residential mortgage-backed C.D.O. markets, Merrill Lynch has no legal responsibility to the city concerning the financial performance of this investment.”

Mr. Mann wrote that Springfield was responsible for making the investments, saying, “The city made its own investment decisions.”

But upon review, Merrill determined that the neither the city nor the Springfield Financial Control Board had authorized the purchase of the C.D.O.’s.