Public Fund Management Needs Expert Touch--and Thus Reform

A number of municipalities and public agencies have been in the news lately after incurring multimillion-dollar losses of invested public funds. An inside look at each case reveals that, although players and circumstances varied, there is a fundamental common cause for the losses: a sometimes shortsighted and often oversimplified approach to an increasingly complex investment-management arena.

Ten years ago, San Jose suffered a $60-million loss on its investment portfolio. More recently, of course, Orange County lost $1.7 billion for the same reasons: Financial officers speculated in government bonds, pledging municipally owned securities as collateral to buy even more bonds with the borrowed funds. When the market value of the bonds held as collateral dropped, securities dealers called for more money, and the county was required to sell securities at a loss to cover the call.

A key point is that in none of the reported financial debacles has there been any evidence that municipal financial officers were anything but well-intentioned. However, good intentions alone are not sufficient for managing large amounts of money in today’s complex financial markets.

Rather than being excessively aggressive, the overwhelming majority of municipal finance officers maintain an overly conservative investment philosophy. Many cities leave investment income “on the table,” sacrificing yield for safety--or so they think. Could it be that many are taking above-market risk to attain below-market returns? Might these same conservative investors be unknowingly in violation of the state code governing acceptable investments, because of the complexities in the code?

Although circumstances vary considerably, one question remains constant: Do municipalities thoroughly examine every available legal investment to best preserve and enhance these public funds?

A misunderstanding over responsibilities also became obvious with the messes in San Jose and Orange County--namely, the heavy reliance of many municipal finance officers on securities salespeople for investment advice. Robert L. Citron, who served 24 years as Orange County treasurer, called himself a “layperson” who depended on Merrill Lynch & Co. securities salesman Michael G. Stamenson, who was also a central figure in the San Jose situation. In a state Senate hearing, Stamenson said that Merrill was “never a financial adviser” to Orange County; “we were a purveyor of products,” he said.

The primary fault for these losses and unnecessary risks really lies with policies and practices that prevent sufficiently expert management of public monies. Important changes are necessary if municipalities and public agencies are to prevent weighty investment losses in the future.

These include:

* More qualified investment managers. Municipalities will not budget adequate funds to train and equip their finance officers. Consequently, we find low salary scales, hiring limitations or lack of opportunity for municipal finance officers to acquire professional qualifications.

The result is that the responsibility for managing large sums of public money frequently falls to an official who is untrained in sophisticated investing or who must handle investing as just one of many finance-related tasks. Expert investing today requires highly specialized knowledge and constant involvement with sophisticated data services. Assigning the investment responsibility to a finance officer as one task among many is courting the danger of major financial loss.

An interesting point to consider is that virtually all municipalities use outside, professional investment managers for their pension funds, but not for their excess operating funds or reserves. Why?

* Clear investment guidelines. Although most states have a code outlining investment policies, in many cases it is poorly defined. It is critical that specific rules governing investments be clear, including the types of investments permitted, maturity limits, maximum exposure amounts to achieve diversification, and who has the authority to make purchases.

* Meticulous procedures. Executing transactions can be complicated, detailed, fast-paced work, and it typically is handled by telephone. Good backup data must be carefully maintained and proven procedures must be established, then followed.

* More care in selecting investments. The wide universe of investment instruments changes constantly. Prices fluctuate. Credit quality shifts. The ability to obtain competitive prices, spot opportunities and avoid grave risk requires not only ongoing, thoroughly professional experience and investment data services, but also appropriate computer hardware and software to make fast, effective decisions.

* Investment diagnostics. To assure that guidelines and procedures are being properly maintained, as well as to monitor the performance of individuals with investment responsibility, professional investment experts should be called in periodically.

Inadequate investment management should not be acceptable where public funds are concerned. The risk of significant loss has proven to be real. It is up to public officials and legislators to recognize the dangers and take remedial action. They must budget the funds required so finance officers either have the tools they need to do a proper job--or can hire an outside firm that does.