INVESTMENT PITFALLS:
Five Simple Rules to Keep You Out of the News
By REGIS SHIELDS, Esq.
What is a derivative? A derivative is a financial
instrument whose returns are linked to, or derived
from, the performance of one or more underlying assets
such as interest rates, bonds, currencies, or commodities. Derivative products can be collateralized mortgage obligations (CMOs), strips of CMOs such as
interest-only obligations or principal-only obligations,
structured notes, forwards, futures, currency and interest rate swaps, options, floaters, inverse floaters, caps,
floors and collars.
What is a reverse repurchase agreement? Reverse
repurchase agreements are the same transaction
viewed from opposite economic positions of the parties. The agreements provide for the purchase of securities (collateral) and the simultaneous commitment by
the seller to repurchase the securities at a set price on a
specific date. The seller is entering into a reverse repurchase agreement.
The Orange County, California bankruptcy filing
and the investment strategies that led that affluent
county to realize investment losses of approximately
$1.7 billion have prompted elected officials, fund managers, and other officials to assess local government
investment portfolios and reevaluate their investment
policies. While a nationwide survey of municipal debt
issuers conducted by Moody's Investors Service in December 1994 confirmed the generally conservative nature of municipal investment strategies, local government officials can learn some valuable lessons from the
Orange County experience.
Orange County's Investment Strategy
Was Very Aggressive
The enormous losses experienced by the Orange
County Investment Pool stemmed from an aggressive
investment strategy based primarily on enhancing
yield. At the time of its collapse, the pool was highly
leveraged through the use of reverse repurchase arrangements which mismatched assets and liabilities.
The pool also had a substantial unhedged position in
derivative instruments that were extremely vulnerable
to interest-rate changes, such as structured notes issued
by federal government-sponsored enterprises.
Rising interest rates resulted in substantial market
value losses on the entire portfolio, and collateral calls
on the reverse repurchase agreements forced the
county to realize those losses. When word of these
market losses reached voluntary participants in the
pool, their demands for withdrawals created a liquidity
crises the portfolio could not withstand.
Clear Guidelines and Monitoring Are Critical
So, what lessons can issuers learn from Orange
County's mistakes and how can investment officials
apply these lessons to their own investment practices?
Here are a few rules that governments should follow to
avoid the pitfalls encountered by Orange County.
Rule number one: Know what you are buying.
Rule number two: Develop adequate controls and
oversight.
Rule number three: Diversify investments.
Rule number four: Match investment maturities to
cash flow requirements.
Rule number five: Adopt a written investment policy.
Rule Number One: Know what you are buying.
Derivatives are not inherently bad. Orange County
officials did not have problems simply because they
invested in complex financial products. Their problems
arose because these products were imprudently used
and managed.
If the government investor does not fully understand an investment and all the nuances of how the
product will perform in different interest-rate environments and market conditions, the investment should
not be purchased. Rewards do not come without risks,
and investments that offer above-market returns are
likely to have some increased risk associated with them.
Investment officials should understand the implications
of those risks before investing in any product, and
should evaluate whether the risks are consistent with
the mandate to manage public funds prudently and
preserve capital.
The obligation to understand and evaluate risks
applies to all investments — not just new or unfamiliar
ones — including investments that are legally authorized by state statute or permitted in the investment
provisions of a bond resolution or indenture. Just because an investment is legally authorized or permitted
does not mean it is appropriate for the particular funds
being invested. In the case of Orange County, reverse
repurchase arrangements were specifically authorized
under California law. Issuers must make independent
decisions about each type of investment on the authorized list.
In addition, government investors should make independent, informed decisions about the suitability or
appropriateness of the product for the specific purposes. They should not rely solely on their investment
agents to make this determination.
The goals of broker/dealers and government investors are very different. While a number of municipalities have sued their brokers for losses on the basis that
Regis Shields, Esq. (212/553-4974) is an assistant vice president in
the Legal Analysis group at Moody's Investors Service, New York.
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June 1995 / Illinois Municipal Review / Page 17
the broker sold them inappropriate investments, brokers are not "guarantors" of investments and local governments should not view them as such. Investment
officials should also be aware that hiring an outside
advisor to handle investments does not absolve them of
the responsibility to manage those public funds appropriately.
Rule Number Two: Develop adequate controls and
oversight
Responsibility for investment activity should never
rest solely with one person. Local governments must
put in place adequate controls and oversight to ensure
that investment decisions are made within the parameters of established policy and that they are consistent
with the objectives for the particular funds. Issuers
should also establish a reporting and review process:
investment decisions and portfolio positions should be
closely reviewed by the appropriate government body
or by officials ultimately responsible for performance.
New and complex financial instruments are constantly being created to meet investors' needs. Investment officials should incorporate new products into
their investment strategy only if they have the expertise
to adequately understand the product. More important,
they must have the staff to monitor the investments and
related risks and be able to respond to changing financial conditions. Some investments possess volatile price
characteristics that require constant monitoring and sophisticated computer models to accurately assess exposure and risk.
Rule Number Three: Diversify investments
Investing primarily in one type of security magnifies
the risks associated with that particular investment. As
the market fluctuates, the performance of a non-diversified investment portfolio will depend on the
strength or weakness of that particular investment.
This effect was particularly notable in 1994 for issuers who concentrated their investments in longer-term collateralized mortgage obligations. As interest
rates rose, these investments lost market value and
created liquidity concerns. Some local governments
realized substantial losses, and had difficulty meeting
cash-flow requirements.
Rule Number Four: Match investment maturities and
cash flow requirements
Portfolio investments should be structured around
anticipated cash-flow requirements. If investors are
careful to select their investment vehicles and match
maturities with cash-flow needs, the market value fluctuations of the portfolio should have little impact on the
local government, even though there may be "unrealized" losses in the interim.
Unrealized losses become a problem when there is a
mismatch between the duration of investments in the
portfolio and either normal cash-flow requirements or
unanticipated withdrawals. When either of these things
happen, the issuer will have to liquidate securities before they mature, and may then be forced to experience
an actual loss.
Rule Number Five: Adopt a written investment policy
Municipalities should develop and adopt an investment policy that details and clarifies investment objectives and the procedures and constraints necessary to
reach those objectives. An investment policy set forth in
adequate detail, combined with appropriate controls,
can guide the activity of investment officials and outside investment advisors. All investment policies should
reflect the mandate to manage public funds prudently
and should place appropriate emphasis on the goals of
safety of principal first, liquidity second, and yield last.
As demonstrated by the Orange County bankruptcy
filing, making investment decisions strictly on the basis
of yield is an imprudent strategy. Safety of principal
should not be unduly jeopardized for the objective of
higher yields.
Page 18 / Illinois Municipal Review / June 1995
In addition to objectives and goals, investment
guidelines should incorporate parameters on market
risk as well as on credit risk.
A highly rated collateralized mortgage obligation
issued and guaranteed by a federal agency is not readily
convertible to cash and difficult to price. If the duration
of the investment does not match the local government's cash-flow requirements, then the security can
turn out to be a highly inappropriate investment, despite the high credit rating.
Investment policies should also specify allowable
investments. Based on the issuer's determination of
what is appropriate for the particular funds being invested, this list may be narrower than state statutory
guidelines. Certain derivative products may be inappropriate for a particular fund or investor, for example.
Government officials who draw up investment policies should apply particular scrutiny to 1) products
with high price volatility; 2) highly leveraged products;
3) products that are not market tested; 4) non-readily
convertible products that are difficult to value; and 5)
products that require a high degree of expertise to
manage, need constant monitoring or sophisticated
computer models.
Investment policy should include guidelines on
adequate controls and monitoring procedures, reporting requirements to the governing body or officials
ultimately responsible for performance, diversification, and maturities of investments. The investment
policy should be reviewed periodically and adjusted to
improve its effectiveness and to reflect changes in the
market.
Conclusion
For many issuers of municipal debt, events in
Orange County were a wake-up call. Many issuers
realized that they did not know exactly what was in
their investment portfolios, or that they had inadequate
procedures in place to review and monitor performance. Orange County's difficulties reinforced the
benefits or diversification as well as the need to match
maturities to cash flow requirements. Undoubtedly the
starting point for many issuers of municipal debt will be
the formulation of an investment policy that incorporates these five rules. •
Page 19 / Illinois Municipal Review / June 1995
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