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Investors, Brokerage Houses Smarting After Heavy Losses

April 30, 1987

NEW YORK (AP) _ April closed out with an upbeat Thursday, but many investors and brokerage houses will remember the month for the steep plunge in the bond market that saddled them with big losses.

A day earlier, Merrill Lynch & Co. highlighted the damage by announcing it had lost $250 million from trading in mortgage-backed securities. The news was not a real surprise to people with money invested in bonds.

Bond prices plunged during April because of the sharp decline in the dollar, which raised fears about a rekindling of inflation and a downturn in foreign demand for U.S. debt. A rise in interest rates drives bond prices down to keep yields competitive with new issues coming to market.

The drop in bonds also fed the sharp declines on Wall Street during the month.

Particularly hard hit were holders of municipal bonds, said Mark Tenenhaus, vice president for municipal bond research at the investment firm Dean Witter Reynolds Inc.

The Bond Buyer, a trade journal, said its index of 40 municipal bonds plunged from 99.594 as the month began to a low of 88.656 on April 14. It stood at 90.344 on Thursday as bond prices rallied after Federal Reserve Chairman Paul Volcker said the Fed had tightened monetary policy to support the dollar.

Tenenhaus said the plunge in bond prices brought out a flood of sellers.

″It was not unusal for any given day to have $500 million in bonds out for bid″ from bond funds, Tenenhaus said.

He noted that in addition to being buffeted by rising interest rates and other economic conditions, the bond funds had to sell bonds because individual investors wanted to take their money out of the funds.

The decline in municipal bonds was further exacerbated by investors worried about protecting their principal as the market declined, Tenenhaus said.

″It feeds on itself,″ he said.

Merrill Lynch lost its money in mortgage-backed securities, which also suffered sharp declines. Mortgage-backed securities are particularly vulnerable to market fluctuations because of their dependence on interest rates and because the decline of the dollar can affect the value of the collateral behind the bonds.

Analysts said other brokerage houses also suffered losses, but not in the magnitude of Merrill Lynch’s loss.

″All firms have had some trading losses in certain aspects of their fixed income inventory,″ said Perrin Long, an analyst with Lipper Analytical Securities Corp.

″Other than Merrill Lynch, it’s highly unlikely that any of the other major firms will report for the whole quarter trading losses,″ Long said.

Merrill Lynch said it expected to avoid a net loss for the quarter because of profits in other areas of its business.

″Merrill Lynch was more heavily engaged in a particular segment that has greater volatility in price, both on the upside and the downside,″ said Long. ″There’s a greater protential for differences in mortgage-backed securities than in the government market.″

Merrill Lynch said its loss resulted from unauthorized transactions by a senior trader, who had been fired, and the market’s volatility. The transactions were considered unauthorized because they involved amounts of money beyond limits set by the brokerage house, analysts said.

″Someone was asleep at the switch,″ said Long, adding that most investment firms have controls to prevent heavy losses and the controls at Merrill Lynch seem to have failed.

The analysts said that with the volatility in the bond market, brokerage houses - and investors in general - are likely to lose more money.

″We’ll see more,″ said Donald B. McLellan, an analyst at Fitch Investors Service Inc.

″The whole industry is becoming more aggressive and needs more capital and is taking more risks with securities in their inventories and trading,″ said McLellan.

But William Sullivan, vice president for money market research at Dean Witter, said that while individual investors and the brokerage firms have suffered losses, they may make some of their money back.

″It’s not a lost cause,″ he said. ″If rates do drop again, and they (investors) retain their positions, they can recover some of those losses.″