DERIVATIVES: RISKY BUSINESS? : County Heads Long List of Losers in the Derivatives Game : Investments: Dozens of public entities have lost hundreds of millions of dollars. As long as fund managers seek big payoffs, there will be more, industry insiders say.
Orange County leads the list of government entities that have suffered big losses--real or on paper--in the derivatives market in the past year. But the county certainly doesn’t stand alone.
Dozens of cities, counties and school districts across the nation have lost hundreds of millions of dollars from investments in derivatives--a little understood investment whose value is tied to, or derived from, the performance of an underlying index or asset, such as stocks, bonds, mortgages or commodities.
And as long as government financial managers are rewarded for finding investments that promise big returns, there probably will be more losses, investment industry sources say.
Orange County, which manages investments for itself and more than 180 other government entities in California, on Thursday reported that the value of its bond portfolio has dropped by nearly $1.5 billion this year because of interest rate hikes and problems linked to derivatives trading.
Orange County’s story is a bit different from most others because County Treasurer-Tax Collector Robert L. Citron, who was reelected last month, actively manages the investment pool and maps out daily investment strategies.
In most other cases, the government entity simply bought into a professionally managed investment fund that put the money into derivatives.
Lawsuits filed or being threatened in a number of cases often are based on a claim by the government agency that it was an unsophisticated participant harmed by an overly aggressive financial management strategy.
In other words, said one industry insider who requested anonymity, “they are saying they were too dumb to know what they were getting into.”
In early October, the head of Odessa College, a 15,000-student school in west Texas, appeared before the House Banking Committee in Washington to describe how a derivatives investment sucked $11 million out of its coffers.
“We feel small political institutions, such as Odessa College, need clearer signposts as to what is advisable or inappropriate,” said Odessa President Philip Speegle. While the school’s managers now know about derivatives, he suggested they could fall victim to some new and equally risky investment vehicle in the future without such warnings.
Sometimes, however, even guidelines aren’t enough. In Charles County, Md., there are written policies specifying appropriate investments. Derivatives are expressly forbidden. Yet the county’s former deputy treasurer pumped almost the entire county investment portfolio into derivatives in 1992 and 1993 and saw the $30 million in principal shrink to $24 million because of trading losses.
And City Colleges of Chicago, a system of seven community colleges with 80,000 students, recently sued a professional money management firm after the value of the college’s $96-million investment fund was cut in half by losses on derivatives deals early this year.
The suit alleges that the Texas-based investment firm arranged to put the college’s funds in such deals though it knew that Illinois law prohibits public schools from investing in derivatives.
In asking Charles County officials for details about the county’s investment losses, House Banking Committee Chairman Henry B. Gonzalez (D-Tex.) opined that “clearly, there is a huge number of supposedly sophisticated managers of public funds, mutual funds, corporate and pension funds, who really don’t understand the arcane risks of derivatives.”
Frederic E. Christiansen, financial director of Maple Grove, Minn., a suburb of Minneapolis, admits that he knew very little about them when he said “yes” to a representative of Piper Jaffray Cos. who was selling the Minneapolis-based brokerage’s Government Institutional Portfolio fund--a fund that invested heavily in derivatives.
Christiansen put $5 million of Maple Grove’s money into the fund in August, 1992. As of the end of November, he said, the value of the city’s investment had shrunk to $3.4 million--a $1.6-million loss if city officials decided to cash out.
That hasn’t happened yet because Piper Jaffray continues paying a guaranteed 8% annual interest rate on the money--by the end of this year, Christiansen said, Maple Grove will have earned almost $1 million in interest over the two years. Another 18 months or so and the interest will have erased the loss if nothing else happens.
“We’re getting about twice the return on that as on our other investments,” Christiansen said in a telephone interview Thursday. Such returns are why the city hasn’t joined other Piper Jaffray clients with big losses in a threatened class action suit against the nationally marketed fund, which was down an estimated $700 million at one point this year.
“Our only contention against Piper,” he said, “is that they didn’t tell us enough about this type of investment and about the risk. These derivatives have gotten a lot of publicity this year, but back in 1992 we knew very little about them.”
Derivative Downers
Orange County on Thursday acknowledged what it said were “paper losses” of nearly $1.5 billion on its investment portfolio. A partial list of other public and private entities that have reported big losses from derivatives trades in 1994. Amounts in millions:
Investor Loss Procter & Gamble, Cincinnati 102 Investors Equity Life Insurance Co., Hawaii 90 City Colleges of Chicago 48 Gibson Greetings Inc., Cincinnati 23 Atlantic Richfield Co. Money Market Fund (employee savings) 22 Odessa College, Odessa, Texas 11 Charles County, Md. 6
Source: Times reports
