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Portfolio risk: staying out of harm's way.

The economy, at the beginning of 1992, has been mired in a recession, the duration of which remains highly uncertain. For municipal governments, revenues from all traditional sources have declined considerably. As a result, fiscal belt tightening and concerted efforts to enhance revenue have come to the forefront, opening the door to potentially risky activities.

Of these risks, those associated with investment portfolio interest income is of paramount importance to local government management. If prudence in the investment of governmental funds is not strictly observed and losses occur, depending on the severity of the losses, the ability of government to meet its obligations could be seriously impacted.

There are always a number of positive techniques for active portfolio management that can have beneficial results when performed in a professional and prudent manner. However, during financial downturns, imprudent and sometimes rash investment decision will occur as a result of either implied or perceived mandates to increase the yield of the investment portfolios.

One remembers the events of the 1980s, when a number of governmental entities took unprecedented losses in their investment portfolios. Most of these losses occurred in 1983 and 1987 when yields on the U.S. Treasury 30-years bond rose approximately 125 to 130 basis points in two and four months respectively. These sharp increases in yields followed a sustained decline in overall yields averaging 330 basis points for each of the two periods. This interest rate scenario created an environment that set the stage for those losses to occur. External factors, such as volatile interest rate shifts, cannot be controlled, but internal reactor to them can be prudently and effectively managed.

Disastrous Results

To learn the lessons of that recent history, one must ask, "What internal factors were present or lacking that led to such disastrous?" The answer suggests that the commonality of factors were: 1) speculation, 2) abrogation of responsibility, 3) lack of internal controls and 4) lack of supersion.

Speculation. Traditional investment policies stressing safety of principal and liquidity gave way to interest rate speculation stressing yield, a policy that embodied both higher market and credit risks. Such changes in basic philosophy are often the result of poorly written investment policies or of a lack of understanding that quantifying market risks and credit risks should be included in the investment policy.

In 1983 and 1987, porfolios that for years had consisted of intruments predominately short-term in nature (three years or less) shifted to long-term instruments with maturities ranging from 10 to 30 years. Long-term securities were purchased solely with the intent of selling them at a gain prior to maturity by portfolio managers who anticipated that interest rates would continue to fall. But they did not secure the concomitant ability to realize losses if their expectations did not materialize--a ploy that is by definition pure speculation.

Excessive investments were made in those years in reverse repurchase agreements, often times employing leveraging, a program designed to fund long-term investments, not one of merely enhancing shor-term cash needs. Also, there was heavey involvement by some governmental investors in "When Issued" (WI) and "To Be Announced" (TBA) trading programs, which by their very nature are speculating on the direction of interest rates. For instance, from the time when WI or TBA securities are priced until the actual settlement date, if interest rates should rise, the purchaser is faced with either selling the securities at a loss or taking them into the portfolio at an interest rate that is below market.

A higher degree of credit risk was assumed by changing the traditional mix of Treasury and agency securities to a portfolio consisting of a large number of medium-term notes, long-term certificates of deposit and mortgage-backed securities.

Abrogation of Responsibility. In the majority of cases, there was either a partial or total abrogation of responsibility as it relates to the management and review of the investment portfilio.

In California, the government code provides for the authority of the legislative body to invest or reinvest funds of the local agency or to sell or exchange securities so purchased. This authority may be delegated to the treasurer of the local agency who them assumes ful responsibility. In practice, responsibility can never be totally delegated. At each level of local government, there is responsibility with regard to the investment portfolio of the city. the legislative body has a duty to assure itself that the adopted statement of investment policy adequately and thoroughly expresses the investment philosophy of the city and that all statutory, legal and contractual provisions are being met. The recipient of this investment authority should be required to report in a format that is thorough and concise and in fashion that is easily understood.

The chief executive officer or manager should meet monthly with the chief financial officer or treasurer to assure compliance with the stated investment policy. Investment strategy and results, as well as any violations or exceptions to policy or statutory requirements, should be discussed.

The chief financial officer or treasurer should not only have a thourough knowledge of the city's investment policy, but also should possess a working knowledge of statutory provisions relating to authorized investments by type, maturity limitations, and the basic credit and market risks of various types of investments. Investment strategy and results, including any variance from existing policy, should be discussed on a regular basis.

Lack of Internal Controls. The investment portfolio of the majority of municipalities represents one of its largest and most liquid assets. A lack of internal control procedures can have serious adverse effects. As witnessed by events that occurred in the 1980s, oftentimes all aspects relating to investments were centered in one individual: the day-to-day investments, all investment accounting, wire transfer, bank reconciliations for both the operating and safekeeping accounts and reporting of results were either performed or controlled by one individual.

To properly safeguard city investments, the individual chaged with investment responsibility should not be involved with the financial accounting for those investments. Financial accounting personnel should be knowledgeable of the city's investment policy and any constraints it places on investment personnel. Ideally, wire transfers, bank reconciliations and securities transactions confirmations would be handled by others as well.

Lack of Supervision. Trust, a valuable and desired commodity in every relationship, is a necessity in every seccessful organization. A certain level of trust must exist between supervisors and subordinates for the operation to function efficiently; blind trust, however, is foolhardy. To para-phrase statements made by individuals involved or privy to events that occurred in the 1980s, one often heard statements such as these at every management level:

"Trust had been built up over the years. There was no need to supervise the individual."

"The portfolio was operating so successfully, there was no need to interfere with its operation."

"I'm not familiar with the daily investment routine, so I leave that portion of the operation to my investment officer."

It is an absolute necessity that each level of management be assured that the city's investment portfolio is being managed in accordance with all policy and statutory requirements. At each level of supervision, duties and responsibilities must be defined clearly and thoroughly understood. Well-written procedures and guidelines must be in place to reduce or eliminate vagueness or ambiguity. To fail in this obligation can produce catastrophic results.


Economists differ on the present state of the economy. Some would say that the recession has ended and the country is on its way to recovery. Others believe that the recession will continue well into 1992. One thing is certain, however: interest rates have fallen a great deal over the past few years and they may indeed fall further.

Because of such uncertainties, investment policies should specifically state the purpose of the fund and quantify the market risks, particularly those associated with long-term securities as well as those related to the creditworthiness of the various investment instruments.

If a governmental entity is presently holding longer than prudent securities position, or a disproportionate amount of low-quality securities, the first quarter of 1992 might provide an opportune time to shorten the average duration of the portfolio. Early '92 alsomight be the time to consider liquidating low-quality securities, assuming that securities could be sold at or above the original purchase price.

Historically, as rates begin to rise, recently purchased long-term securities decline in price and spreads between quality securities and low-grade securities begin to widen. This could create a severe loss if the city has to liquidate its holdings. Those governmental entities that sustained serious losses in the 1980s had reaped substantial paper gains from speculation, but the gains were never realized, the agencies suffered needlessly and were put in a financially crippling position.

If such losses occur in the future and some major problem develops, a number of the government's officials could find themselves in a very tenuous position, even though a specified individual is the named delegee of investment authority and responsibility. Therefore, it behooves all levels of government to take an active role in the management and supervision of the entity's investment portfolio. If staffing or resources are limited, it may be desirable to place a portion, or in some cases, the majority of funds with either state or county investment pools. This will provide safety and liquidity, as well as diversification not available to small portfolios managed in-house.


A successful career in any chosen field does not occur accidentally nor through happenstance; professional reputations are established over a period of many years. Individuals who fell victims to the events of the 1980s were primarily professionals, who in no way profited personally from the losses.

A number of careers were ruined or seriously tarnished. Perhaps the most serious consequence of all was the fact that the entity's reputation and financial soundness were adversely impacted, or at the very least, impaired to some degree. The stark reality of staff shortages and dwindling resources and the challenge this presents is almost pleasant when compared to the specter of explaining the fiscal train derailment to an outraged citizenry and legislative body.

Because of the severe economic and financial conditions currently facing government finance officials, it is imperative that every portfolio manager insure the safety of the agency's assets.

Henry Davis is chief investment officer, Treasurer's Office, City of Los Angeles.
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Title Annotation:Forum; managing government entities' investment portfolio
Author:Davis, Henry
Publication:Government Finance Review
Date:Feb 1, 1992
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