The disclosure that MDL Capital Management lost $215 million for the Ohio Bureau of Workers' Compensation raises many troubling issues, not the least of which involve the activities of the Ohio agency's current and former employees.

But here's another question that has observers scratching their heads: Given Ohio's investment problem, why did the agency and Downtown-based MDL Capital come up with the solution they did?

Ohio says MDL Capital, founded by rags-to-riches Aliquippa entrepreneur Mark D. Lay, proposed a way of shielding the fixed income portion of the $14 billion workers compensation fund from an anticipated rise in long-term interest rates. With the Federal Reserve Board steadily ratcheting up short-term rates, Lay wasn't the only bond investor expecting long-term rates to go up even faster. Because bond prices move in the opposite direction of interest rates, rising rates would have caused the value of long-term bonds to drop.

Investment advisers, all of whom asked not to be identified, said the easiest way to ameliorate the risk of rising rates would have been to sell long-term bonds and replace them with short-term debt. Some argued that because the Ohio fund had a good idea of its future liabilities, just a little fine-tuning of its portfolio would have taken care of the problem. They say that's what insurance companies, foundations and other large investors would have done.

Instead of the simple approach, Ohio says Lay suggested something more complex: "shorting" long bonds. There's a number of ways to do that, but essentially Lay borrowed bonds and sold them, hoping to repay the loans after interest rates rose, causing bond prices to fall.

But long-term rates confounded experts and fell even as short-term rates rose, turning Lay's bet into a losing proposition. MDL Capital's losses were magnified because Lay used futures contracts, which offer much greater leverage than owning the actual bond.

It's comparable to placing a $5 bet with the chance to win $100 -- as well as the chance to lose $100, or more than you invested. Observers say that from the facts at hand, it looks like Lay lost one $5 bet, made another one to recover his losses and lost again, then did the same. In other words, $15 worth of bets turned into $300 in losses.

Meanwhile, the bonds Ohio was worried about losing money on actually gained value -- remember, values move opposite from rates, which were falling -- but apparently not enough to offset the losses MDL Capital was ringing up.

The $215 million loss amounts to about 1.5 percent of the Ohio agency's assets, and Ohio's investment consultant says nearly 85 percent of the loss resulted from MDL Capital exceeding risk limits.

Lay maintains he abided by the terms of the investment contract, and in a statement released Friday said the strategy was a prudent way to protect the agency's overall holdings.

What Ohio says Lay proposed was a sharp departure from MDL Capital's traditional business of investing in bonds. His meteoric rise in the money management business -- from $0 to $4 billion in about 10 years -- raised a few eyebrows. MDL Capital's performance in the plain vanilla pursuit has also been raising eyebrows for several years.

A number of clients have dropped the firm because it hasn't been able to beat market indexes, benchmark measures of what a bond investor such as Lay should be earning. Such was the case at the Retirement Board of Allegheny County, which dropped Lay last week after the losses in Ohio were disclosed. Given the dissatisfaction with MDL Capital's results, don't be surprised if more clients use the train wreck in Ohio as an opportunity to do the same.

The Securities and Exchange Commission's top economist made an interesting observation on executive compensation last week at a forum on the Sarbanes-Oxley Act.

Chester S. Spatt, who has taught at Carnegie Mellon University since 1979, was the luncheon speaker at the session, sponsored by Spatt's other employer, CMU's Tepper School of Business. The meeting was designed for executives and lawyers who have to deal with the 2002 law, the most ambitious revision of securities law since the Great Depression

Spatt's speech covered a number of aspects of doing business in the post Sarbanes-Oxley world: the role of boards of directors, executive compensation and employee stock options. The latter has been the subject of much debate in recent months.

The Financial Accounting Standards Board, the accounting industry's lawgivers, wants companies to recognize the expense on issuing options on their profit-and-loss statements. Many oppose the move, saying it would discourage a form of compensation popular at technology-based companies that help the U.S. economy grow. The SEC recently gave companies a six-month reprieve from expensing options.

In his remarks, Spatt noted that some of the biggest users of stock options are among those complaining the loudest about expensing. They argue that it is difficult to determine the value of options. And if you can't determine their value, how are you supposed to record them on your income statement?

Spatt's point: If companies don't know how much they're spending when they dole out options, how do they know whether they are paying executives appropriately?

"It does raise the question of how a firm can be comfortable that it is meeting its fiduciary responsibility to its shareholders when a substantial portion of its compensation is paid through a tool whose anticipated cost it does not understand and cannot qualify," Spatt said.