Investment: Protecting Your Funds

Are your municipality’s assets safe?

by Robert Inzer

Most of us are familiar with Bernie Madoff, who created the largest Ponzi scheme in U.S. history and swindled investors out of tens of billions of dollars. There were only a few local governments nationally that had invested in his fund. He was not the first unscrupulous investment manager and won’t be the last. Let’s not forget about ESM Government Securities Inc., a South Florida-based securities dealer that swindled investors out of over $300 million in the mid-1980s. Investors that lost money included several South Florida cities.

Orange County, CA, this year retired the last of the outstanding bonds sold to bail the County out of its 1994 bankruptcy. It was the largest U.S. county ever to declare bankruptcy. The bankruptcy was caused by the County Treasurer’s overly aggressive investment strategies while leveraging county funds. The securities involved were government agency-issued derivative securities tied to a specific interest rate outlook. It turned out that the market values of these bonds were highly volatile. The securities never defaulted, but when unanticipated interest rates movements occurred, the value of these securities plummeted. The County sold $1.6 billion in debt to fund the losses.

In addition, there have been significant losses incurred by Florida cities arising from investments in assets they did not fully understand, with risks not fully appreciated. New investment instruments seem to regularly emerge from Wall Street dealers, each being a little more exotic than the last. By 2006-2007, we had local governments investing in bonds backed by subprime mortgages, where the underlying loans were highly risky. Some cities purchased more exotic instruments. They bought specific tranches of mortgages whose return was often unpredictable and ran counter to the market. These securities were rated AAA by Moody’s and Standard & Poor’s rating services and thus qualified for investment by most investment policies at the time. These same securities were downgraded to below investment grade status, declined in value and even defaulted.

Florida’s Local Government Surplus Funds Trust Fund (now Florida Prime) also purchased securities they did not fully understand or appreciate. When the investments became illiquid, the state was forced to withhold access by participating governments to some of their funds for years. Many local governments and the Florida Local Government Investment Trust were invested in large blocks of these securities and incurred significant losses. If these large institutions can make serious investment mistakes, don’t assume that your government is immune.

The State of Florida has recognized the risk associated with the investment of your government’s investment portfolio. Over the years, it has taken steps to help protect you from unscrupulous brokers marketing investment products inappropriate for your portfolio and unsophisticated staff managing these assets. Florida Statutes 218.415 addresses local government investment authority and requires certain safeguards to protect you and your citizens from future losses. Among other things, it requires each unit of local government to adopt an investment policy approved by the governing body, or alternatively, restricts investments to AAA-rated money market accounts, certificates of deposit, time deposits in selected institutions and the Local Government Surplus Funds Trust Fund operated by the State Board of Administration.

Most cities have opted for broader investment authority and have adopted investment policies. Florida Statutes require that the policy describe the following investment objectives: safety of capital, liquidity of funds and investment income, in that order. Your policy should not only reflect these objectives, but its implementation by staff should reflect these priorities. If all local governments had followed these objectives, our investment return might be slightly less, but we would have avoided the big mistakes and subsequent large losses.

ANDREYPOPOV/ISTOCKGETTYIMAGESPLUS/GETTY IMAGES

As a member of the elected body, you should recognize that the investment policy is your policy, not the staff’s policy. By law, you are required to approve it. You should periodically review the policy to ensure that the policy reflects your government’s risk tolerance and is also being adhered to. No one expects you to be a security expert. But you must review the policy and review periodic portfolio reports. If you don’t have the expertise to effectively review the policy and investment report, consider creating an external investment oversight board composed of individuals with specific investment-related experience.

Florida Statutes 218.415 sets forth the minimum requirements for your policy. These include performance measurements, ethical standards, a listing of authorized investments, maturity and liquidity requirements, portfolio diversification requirements, portfolio composition and reporting requirements, among others. Your staff with investment responsibilities are required to complete at least eight hours of investment training annually. Lastly, staff must prepare a report annually, at a minimum, and include a listing of assets, book value of investments, income earned and the current market value of investments and submit it to the elected body for review.

These requirements are to ensure oversight and protect your city’s assets from losses. Historically, losses have not been a function of fraud or theft by staff, and in fact, I’m unaware of any city that has lost money on their portfolio due to criminal activities of staff. Losses have always been a function of investment officers reaching for yield and/or purchasing securities when they did not fully appreciate the risk.

Often the investment function in smaller cities is just one of dozens of responsibilities the Finance Officer has to manage. The Florida League of Cities has recognized the potential problems due to lack of training and created the Florida Municipal Investment Trust (FMIvT) as an alternative investment instrument for cities. Created after several cities were experiencing losses with their investment management, FMIvT is the oldest pooled investment program in the state. In the 30 years it has operated, there has never been a participant that has lost money or been unable to access their funds when needed.

The League has taken the requirements of Florida Statutes 218.415 seriously and created products designed to provide municipal participants with a safe, secure investment program that minimizes the efforts of your staff and provides a competitive investment return.

The Trust has a number of investment options for your excess cash investments, including the 0-2 Year High Quality Bond Fund, the 1-3 Year High Quality Bond Fund and the Intermediate High Quality Fund, all of which are AAA-rated by Fitch Investor Services and designated an S1 rating for the lowest sensitivity to interest rate changes. Remember, the first two objectives of your investment policy are to minimize risk and provide adequate liquidity. There is no other investment program with higher ratings than those received by the League’s investment program.

The League retains a nationally recognized fixed income manager with seasoned professionals to provide professional money management. They have established disciplined investment guidelines to ensure underlying investments are diversified and minimize concentration risk. Portfolio duration is limited to ensure liquidity. The League’s professional staff and nationally recognized rating agencies rigorously monitor the portfolio’s instrument selection, diversification, durations and other internal controls.

Over 30% of the assets must be invested in U.S. Treasury or agency securities. Currently, 100% are invested in direct U.S. government obligations or U.S. government agencies. These securities have the lowest risk and highest liquidity. Only the longer duration Intermediate Bond High Quality Bond Fund allows any significant investment in corporate securities.

We know from history that the security markets, investment instruments and overall portfolio management change with time. The League recognizes the standards we have today may not be the appropriate standards for tomorrow. They have created an independent investment Advisory Committee that meets quarterly with League staff, money managers and external performance management consultants to continuously review the overall program, investment options, investment guidelines and performance. This Committee is composed of local government Finance Officers with sophisticated investment management experience. They advise the staff and the Board of Trustees on changes that need to be made to protect your city’s assets and ensure a competitive return.

The FMIvT is the oldest and most secure investment program in the state. You can find funds that have higher returns, but you can’t find a fund with more safeguards to protect you and your city. One thing I learned in my finance classes in college was there is a direct relationship between risk and return. So, if you are getting a higher return, you are most likely assuming more risk.

The FMIvT was created to protect municipal leaders and their cities. As an investment professional, I agree with Will Rogers’ investment advice: “I am more concerned about the return of my money than the return on my money.” Your citizens will seldom question you if your return is a little lower than your neighboring city, but they will be greatly concerned if you incur losses in your investment’s portfolio. They don’t know what you should earn, but they know without question that you should not be incurring losses.

Robert Inzer is an advisor to the Florida League of Cities. He has 46 years of municipal finance experience that includes 30 years with the City of Tallahassee, 20 years of which was spent as City Treasurer-Clerk.