Report 95101 Summary - June 1995

County Investments:

Treasurers Should Avoid Risky Investment Strategies

HIGHLIGHTS

Several counties employ at least one of three investment strategies we consider too risky.

These high-risk strategies include excessive concentrations of structured notes, overuse of reverse repurchase agreements, and holding too many long-term securities.

Additionally, three counties utilized agents who are also custodians to make investments that are not required to be recorded in accounting records or disclosed to participants.

County treasurers are responsible for the receipt and safekeeping of all funds belonging to their respective counties and any additional monies deposited by other participants in the counties' investment pools. However, we found that several county treasurers may employ risky investment strategies in their management of public funds. These strategies run counter to the counties' investment policies and the principles of prudent investing, namely safety, liquidity, and yield, in that order. We surveyed 57 county treasurers and found that several counties, including 7 of the 8 counties we visited, employ at least one of the three strategies that we believe can put public funds at risk. Such high-risk strategies include holding excessive concentrations of often volatile structured notes, excessively leveraging or borrowing against portfolios through reverse repurchase agreements, and investing significant proportions of portfolios in securities with longterm maturities. These strategies increase the affected portfolios' sensitivity to interest rate changes and reduce the ability of county treasurers to meet unanticipated cash needs. Also, they expose portfolio participants to increased risks.

Although the risky investment strategies we discuss in Chapter 1 were also used in Orange County, fortunately, none of these practices were taken to the extremes we found in that county. While we found that all counties we visited experienced unrealized losses to their portfolios as of March 31, 1995, these losses would not be realized unless the securities whose values had declined were sold prior to maturity. The eight treasurers from these counties stated that they had sufficient liquidity in their portfolios to preclude the sale of securities prior to maturity and, therefore, none believe that they will incur any actual losses.

Specifically, we found the following:

  • Seven of eight counties we visited held concentrations of structured notes in excess of 30 percent of their respective portfolios as of March 31, 1995. Many structured notes are not actively traded and, therefore, are harder to accurately price and sell, are typically considered less easy to convert to cash, and are more sensitive to changes in interest rates that can decrease their market value;
  • Four counties we reviewed leveraged their portfolios by more than 40 percent sometime during 1994, with one county leveraging its portfolio as much as 80 percent. Significant use of leverage dramatically magnifies the portfolio's exposure to risk; and
  • Six of the eight counties we reviewed managed portfolios of investments with maturities averaging 2.5 years or more during 1994. The average maturity for one county's investments was an astounding 27.9 years. When most of a portfolio is made up of securities with long maturities, the portfolio is much more sensitive to interest rate changes, and the treasurer's ability to meet unforeseen cash demands is more limited.

According to our investment experts, employing these investment strategies can be inappropriate for short-term investment pools like those used by the counties because they do not emphasize safety and liquidity over yield and expose the portfolios and their participants to increased risks.

Furthermore, some counties are using agents, who in many cases also act as the securities custodians for the same counties, to execute securities lending and/or reverse repurchase transactions on behalf of the counties. Agents acting on behalf of three counties we reviewed performed hundreds of millions of dollars worth of securities lending and reverse repurchase transactions that current regulations and guidelines fail to address. Therefore, these transactions are not reported to oversight agencies and pool participants, were not reflected in the counties' financial statements or clearly disclosed in footnotes, and were not considered by the counties when determining compliance with pertinent investment laws and county policies.

In addition, we found the following:

  • The investment pools of the three counties that delegate their investment authority to agents bear all the risk if investment losses occur, while the agents share between 30 and 50 percent of any profits. In one county these rates were not competitively bid; and
  • Two of the three agent agreements we reviewed allowed the agents to buy and sell securities with their affiliates. This allowance raises questions about ethical and prudent investments.

Recommendations


To improve the investment practices of local governments, we recommend that the Legislature amend the California Government Code. A few of our key recommendations are to:

  • Require written investment policies for all local governing bodies to ensure that safety and liquidity are paramount to yield;
  • Limit the use of reverse repurchase agreements to 20 percent of the portfolio and only for specified purposes;
  • Establish and define a prudent person rule for local investment officers;
  • Limit the use of derivatives or other structured investment instruments and prohibit those that put principal at risk. None of these instruments are to be purchased with borrowed or leveraged funds. Further, the derivatives or structured investments purchased should be openly traded in the secondary market on a recognized exchange. Any investments in these instruments should be limited to no more than 5 percent of the portfolio;
  • Competitively bid separately for lending agent and custodial services, and ensure that all county investment activity by agents or the county are properly recorded and disclosed to interested parties; and
  • Require investment reports, at least quarterly, to the governing body and investment participants.

To manage county investment portfolios using the basic principles of prudent investment practices, we recommend that the treasurers of the counties that employ any of the highrisk strategies do the following:

  • Avoid the use of these risky strategies in the future;
  • Prudently divest themselves of structured notes that add risk to their respective portfolios;
  • Limit future purchases of structured notes that increase risk to the portfolio (as measured by a duration analysis) to no more than 5 percent of all investments;
  • Confine the use of leverage in their respective portfolios to 20 percent or less; and
  • Prudently restructure their respective portfolios to reach an average maturity of no more than 2.4 years.

Further, those county treasurers who participate in a security lending program should do the following:

  • Include agent transactions in statutory limitations and compliance reviews;
  • Report on the security lending program in the counties' annual financial reports and in reports to boards of supervisors and pool participants;
  • Competitively bid for lending agent and custodian services; and
  • Preclude agents from dealing with their affiliates.

Agency Comments


Because the counties believe we used Morningstar Mutual Funds as the basis for concluding that their respective portfolios were too risky, they disagreed with many of the findings and recommendations contained in our report. Specifically, the counties disagreed with our characterization of the counties' use of structured notes and the average length of maturity for their respective portfolios. Individual counties also raised other concerns relating to the tone and content of the report. Since we did not conclude on the counties' investment practices based on the Morningstar data as they assert, we have responded to these and other concerns raised by counties after each county's response.


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