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The Public Lynching of Thomas Zimmerman

The fall of a former pension fund officer proves that derivatives is still a four-letter word.

By Robert Hunter

To anybody scanning the headlines, it looked like another garden-variety derivatives blow-up. "Teacher Pension Investment Losses Hit” read the Chicago Sun-Times. "Teachers Fund Deal Examined By State Audit Reveals Pact With Ex-Manager” and "Pension Chief Denies Foul Play” screamed the Chicago Tribune.

It was another example of a state government's fiscal incompetence: an investment officer at apublic pension fund leaves to start his own fund at 25 times his former pay—and then proceeds to lose $266 million of the state's money in a series of disastrous derivatives trades.

That is how the story of Thomas Zimmerman, former chief investment officer of the Illinois Teachers' Retirement System, played in the Illinois press. During the course of a 20-month saga, the fund's executive director, Robert Daniels, was excoriated in the press for approving seemingly unethical contract with a former employee, and Zimmerman and a number of other fund managers were fired.

But a closer look at the facts in the case shows that there was nothing unethical about Zimmerman's contract, and that his allegedly botched derivatives trades were in fact reasonable actions any hedging-oriented manager would have taken.

By the book

In 1994, Zimmerman decided to leave his $106,000-a-year position as chief investment officer to start Zimmerman Investment Management Co. (ZIMCO). After informing Daniels, the fund's executive director, that he would be leaving, the two began discussing a future business relationship. Daniels was impressed with Zimmerman's performance—the fund doubled in size during his six years with the organization, from $6 billion in 1988 to $12 billion in 1994—and believed it was in the fund's best interest to continue their relationship.

The board of directors agreed. The fund's investment policy allowed it to hire former employees as investment managers if it so desired. It awarded ZIMCO a contract to provide downside protection for a $500 million domestic equity portfolio, a $400 million foreign currency portfolio and a $300 million domestic bond portfolio.

"Chicago and Illinois are very political, and I think the guy's getting a raw deal. He's getting screwed by the press.”

Aware of the possible appearance of impropriety, Daniels hired an independent law firm to iron out the details of a temporary contract. ZIMCO was paid based on the fund's lowest salary structure for managers—10 basis points plus a performance fee if it outperformed its assigned benchmarks. The 10-basis-point fee put ZIMCO in the bottom 10 percent of the firm's 60 managers. Conventional equity managers, by contrast, were paid 40 to 50 basis points.

During the first year of the contract, Illinois Teachers hired a pension consulting firm to conduct a national search for a currency overlay manager. ZIMCO's relative performance against the competition was good enough to keep him on board. During this period, the firm began taking on more clients, and increased its staff from two to eight. It picked up a number of smaller accounts from high-net-worth individuals and was hired to perform currency overlay for an Austrian bank.

No finding

The trouble began when State Auditor General William Holland ordered a routine audit of the fund for 1994–95. The report, released in March 1996, noted some of the facts in the case for the record, but failed to make a finding. In auditing parlance, failing to make a finding implies that no improprieties were found.

Nevertheless, the press seized on the details released in the report as evidence of the misuse of public funds. And Illinois politicians latched onto the report like underfed pit bulls. Sen. Steve Rauschenberger (R-Elgin), the chairman of the senate appropriations committee, told the Chicago Tribune that he was "astounded” by Holland's report. "I'd like to see what the hell [Zimmerman is] doing for $2.5 million when he was doing something of the same nature for $106,000,” Sen. Vince Demuzio (D-Carlinville) told the paper. Rep. Bob Biggins (R-Elmhurst) said the contract was "atrocious” and an "outrage.”

Zimmerman's contract with the fund, however, continued in force through 1996. State Auditor General Holland, perhaps aware of the political capital he was accumulating, called for a second audit of the retirement fund. But instead of focusing on a cross-section of the fund's various managers, Holland ordered an audit that focused strictly on Zimmerman's firm during the 20-month period ending June 30, 1996.

This second audit, conducted by KPMG and released on April 23 of this year, concluded that "total losses in ZIMCO-managed accounts through June 30, 1996, were approximately $266 million, of which some $234.3 million in losses occurred in FY95 and another $31.7 million in FY96. Comparing ZIMCO's performance to the benchmarks established by [the Illinois Teachers' Retirement System] shows that these losses exceeded the benchmarks by approximately $178.9 million.”

No loss

Accusing a manager hired to construct a hedging program of "losing money” makes little sense, says Zimmerman. He offers an analogy: "A prudent person does not cancel his or her property insurance, nor is he or she unhappy, simply because he or she has not recently suffered fire or other property damage.” The audit report, in essence, accused Zimmerman of doing what he was hired to do.

ZIMCO hedged the fund's domestic equity portfolio with S&P index futures and index puts. The bond side was hedged with the Chicago Board of Trade's 30-year Treasury bond contract. The currency overlay on the fund's foreign equity portfolio was constructed with a combination of bank forward contracts and currency futures and options contracts—all standard hedging fare.

But even the best possible hedging program will drag down returns in a bull market. The losses on the hedge positions, of course, are counteracted by the growth in the underlying assets. And that is precisely what the state auditor general and the local press failed to understand. "If you hedge in a bull market, you're going to lose money,” explains one pension consultant. "That's the whole point. They got lower volatility as a result, but nobody cares about lower volatility if you're losing $260 million.”

The audit, however, failed to account for the value of the underlying equity assets. Zimmerman and Daniels both questioned the validity of the report. By factoring the underlying assets into the equation, they calculated a "loss” of $46 million over the 20-month period in question—still a sizable figure, but an understandable hedging outlay in a runaway market.

"It's not fair to compare what he made as a salary with what he made as a money management firm. It's a nonsense comparison. His contract was industry-standard—it's a part of the business.”

Although Daniels had reportedly battled with Holland over the methodology of the audit, Holland did not relent. The audit report explicitly stated its objective: "the report is intended to present an analysis of the related transaction gains and losses over which this individual investment manager had control and is not intended to encompass overall analysis of the System's risk management and overlay program.” The Sun-Times reported that Holland refused to acquiesce to Daniels because Zimmerman "had nothing to do with the increased value of the underlying assets that he was paid to protect.”

The second audit did not make any accusations of impropriety in Zimmerman's fees. It merely pointed out the difference between Zimmerman's salary as a public official and his firm's income. There is no law, of course, that prevents a pension officer from starting a money management firm, and doing so introduces overhead costs into the salary vs. fee debate. "It's not fair to compare what he made as a salary with what he made as a money management firm,” says a pension consultant. "It's a nonsense comparison. His contract was industry-standard—it's a part of the business.”

End of an era

In November 1996, five months before the second audit report was released, the board terminated all of the derivatives-related programs, ending the fund's hedging efforts. The $15 billion public fund, the first in the nation to institute a currency overlay program, today remains totally unprotected from market downturns.

Zimmerman believes the entire mess could have been avoided if he were judged by the proper criterion. "The sad part of this whole thing is that the entire business is about risk-adjusted rates of return,” he explains. "That's what all funds should be measured against, and the politicians don't even look at it.”

Zimmerman's colleagues are unsettled by his situation. "He was just doing his job—he was hedging,” says a pension consultant. "I think there's a huge difference between that and, say, Orange County, where the guy was making huge interest rate bets on his portfolio. People are just getting that angry mob mentality.” Another consultant was even more blunt: "Chicago and Illinois are very political, and I think the guy's getting a raw deal,” she says. "He's getting screwed by the press.”

ZIMCO, however, is still a viable organization. Zimmerman has kept his other clients and has picked up new consulting business advising other money management firms on hedging programs. "I've worked in the political arena for several years now and I understand the issues,” he says philosophically. "I think what's happened to our business is unfortunate. But people recognize that. We're going to be around for the long haul.”