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.

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