"SLY" investing encouraged in the public sector.

Recent losses of public funds through participation in investment pools engaged in risky practices have sparked widespread concern. The investment practices of local governments have come under intense scrutiny. Citizens are questioning their local officials. State legislators are considering more restrictive investment statutes. Individual jurisdictions are examining their portfolio holdings and are reconsidering their own investment policies. This attention to public-sector investing has highlighted the need for those officials who are entrusted with investing public funds to go back to the basics: safety, liquidity and yield (SLY), in that order.

The recent publicized investment problems can be traced to a few root causes. First, many of the reported losses were associated with investments in highly volatile instruments, known collectively as derivatives. Financial derivative products are riskier than other types of investments due to their complexity and the volatility of their market values. When evaluating derivatives, the investor must make predictions on the direction of interest rates. If the prediction is wrong, loss of principal can result. Much of the danger associated with derivative products results from the loss of market value when interest rates move rapidly. Experience now shows that such instruments expose investors to increased interest-rate and market risks.

Borrowing to increase the rate of return on investments - leveraging - also has been the cause of unprecedented losses of public funds. These losses followed earlier reports of public investors who failed to follow diversification practices and invested the majority of their portfolios in risky instruments, such as principal-only or interest-only strips.

The fallout from these publicized losses is significant. Regulators and rating agencies scrutinize debt issues, and governing bodies question finance officers closely. The loss of confidence in local government investment pools has sparked a run on pools around the country. Many state legislators have proposed, or are contemplating proposing, legislation to limit local government autonomy and investment authority. Another major problem, of course, is that investment losses translate into budget shortfalls.

The safety of public funds always has been a major concern of the Government Finance Officers Association (GFOA). The association regularly undertakes a range of activities that promote sound cash management practices. In the early 1980s, GFOA's Committee on Cash Management developed model investment legislation that identifies appropriate investment options for local governments' written investment policies. It recommends that the local policy-making process include explicit consideration of such issues as prudence, diversification and staff competence.

GFOA's model legislation also addresses investment pools. Provisions relating to the method of establishing pools, the creation of an oversight board, and rules and regulations for the administration of the fund - including authorized investments, allocation of losses, and procedures for custody and safekeeping - are included.

To help public officials follow safe and prudent cash management practices, GFOA has developed policy statements and recommended practices to provide professional guidance to finance officers. In June 1994, the association developed two prescient official positions in response to increased interest regarding the use of derivative products, reports of derivative losses and intense marketing of these products by the broker/dealer community. The recommended practice urges finance officers to exercise extreme caution in the use of derivatives and to consider their use only when they have developed a sufficient understanding of the products and the expertise to manage them.

The association also is working closely with other organizations to improve cash management practices. In cooperation with the National Conference of State Legislatures, GFOA will offer a one-day seminar that will provide a forum to discuss state investment statutes as they apply to local governments, state involvement with and oversight of local government investment pools, and the appropriate elements of local investment policies.

Meanwhile, the association's efforts at the federal level continue at full force. It has testified several times before congressional committees concerning derivative products and investment issues. On January 6, GFOA president Bonnie Ridley Kraft spoke before the Senate Committee on Banking, Housing and Urban Affairs regarding state and local government cash management practices and urged the committee to focus on suitability issues and assure that products recommended by broker/dealers are appropriate for the governmental entity.

GFOA urges public officials to take steps to ensure the safety of public funds. Any active portfolio management strategy contains an inherent element of risk. When evaluating an instrument for potential investment, safety of principal should be the foremost consideration; the investor must not overlook the risk of the investment losing value if interest rates change direction. It is imperative that all risks involved in any particular investment - market risk as well as credit risk and default risk - be examined and that the timely liquidation of the instrument and its marketability at competitive prices be considered.

Written investment policies are important safeguards for the investment of public funds. GFOA has established sound investment criteria to assist state and local governments in developing investment programs that protect public funds while enhancing interest-earning potential. GFOA also recommends that investment policies be approved by governing bodies and reviewed and updated at least annually. Policies should list specific, approved investment instruments, broker/dealers and financial institutions. To achieve safety objectives, officials should follow recommended practices of third-party collateralization, safekeeping and delivery-versus-payment and limit risk by adopting diversification requirements. Other investment safeguards include the establishment of a review committee to oversee investments and investment practices.

GFOA also cautions public cash managers who are contemplating investments in local government investment pools and mutual funds to question the returns of these funds. Any pool or fund that earns above-market rates of return has increased its risk. As the saying goes, if it sounds too good to be true, it probably is.

By following the basic tenets of investing, newsworthy losses of public funds can be avoided. Safety of principal, liquidity and yield - in that order - remain the foundation of public investing.

JEFFREY L. ESSER is executive director of the Government Finance Officers Association.