WASHINGTON -- The $1.5 billion in paper derivatives losses suffered by Orange County, Calif., is triggering increased scrutiny by Congress and regulators, including a vow by a top lawmaker to hold hearings early next year on the risks derivatives pose to states and localities.
Sen. Alfonse D'Amato, who will be the new head of the Senate Banking Committee, said Friday that the county's loss "is by far the biggest loss to date from derivatives instruments." The New York Republican said, however, that legislation is not warranted at this time.
Despite the magnitude of the county's loss, a top banking regulator said yesterday that he could not comment on the county's situation.
"This is a new and growing area which does present risks," and it is important that banks adhere to appropriateness standards contained in federal guidance when they sell derivatives products to purchasers such as municipalities, said Eugene Ludwig, the U.S. comptroller of the currency.
But Ludwig said that while individual losses will occur in the market from use of derivatives, "this is a period in which the banking industry is very strong."
The comptroller's office has been working with other bank regulators to develop suitability standards with respect to government securities.
Orange County's woes in its derivatives investment activities is likely to spark even more congressional inquiries into the risks these instruments may pose for state and local governments, a congressional aide said.
"The size of this loss and its effect on municipalities is going to spark careful congressional review," said an aide to Rep. Jim Leach, R-Iowa.
Leach, who is expected to head the House Banking Committee, has said that derivatives will be on his committee's agenda.
Last year Leach introduced legislation that would bring oversight of over-the-counter derivatives under one regulatory body headed by the Federal Reserve and consisting of regulatory leaders from the Securities and Exchange Commission, the Commodities Futures Trading Commission, and the banking agencies.
Rep. Henry Gonzalez, D-Tex., the current chairman of the House Banking Committee, agreed that Orange County's reported losses make the issue of derivatives even more critical for lawmakers. In a statement released late last Thursday, Gonzalez urged Republicans in the next Congress to address the issues.
"I urge the incoming Republicans to do the right thing and work to curb derivatives speculation," Gonzalez said, adding that the Orange County loss "is further proof of the hazards posed by these often misunderstood exotic financial instruments.
"Now you can add Orange County to the ever-growing list of investors who thought they could beat the house," Gonzalez said.
Last Thursday, officials from Orange County said the county's pooled investment fund, which has about $7.5 billion in assets, has experienced a paper loss of about $1.5 billion, largely as a result of its investments in derivatives, including some government securities derivatives.
SEC officials said the agency is aware of Orange County's expected losses and is monitoring the situation.
SEC commissioner Richard Roberts said the agency is concerned that volatile instruments have been making their way into less sophisticated investor markets.
"Now investor makeups include state and local governments and pension funds," Roberts said.
Meanwhile, recent efforts by lawmakers may set the stage for increased protections when municipalities invest in some derivatives, which would include structured notes, one congressional aide said.
"This is an area where Congress has made progress," said an aide to Rep. Edward Markey, D-Mass., adding that regulators now need to establish improved sales practice rules for dealers that sell government securities including government-issued structured notes.
"The ball is in the regulators' court," the Markey aide said.
The SEC's Roberts noted that those rules aren't going to help municipalities this year because they haven't been implemented.
"It's a shame that those rules are not in place," Roberts said. Roberts agreed that stronger sales practice rules may result in less speculative investments in derivatives by municipalities.
"The existence of strong sales practices are in demand and would dampen enthusiasm for many investors wanting to invest in derivatives," he said. Regulators have emphasized that derivatives serve a better purpose when used as a risk management tool as opposed to a speculative investment.
Last December the Government Securities Act was signed into law, giving regulators -- including banking regulators -- the authority to set stringent sales practice rules for dealers that sell government securities.
Congress recognized years ago there were problems in the government securities market area, particularly with respect to structured notes, the Markey aide said. The telecommunications and finance subcommittee of the House Energy and Commerce Committee held hearings in 1991.
Lawmakers maintain that the government securities market has changed. "This is not your grandfather's government securities market," the aide said. More than just the traditional government securities are being sold, he added.
Many of the losses reported by state and local governments have been the result of investments in interest rate-sensitive structured notes issued by government-sponsored agencies.
"With respect to Orange County, the manager seemed to dive head first into some investments," the Markey aide said, adding that a large portion of the investment activity was speculation as opposed to risk management.
The National Association of Securities Dealers is currently in the process of establishing sales practice rules that could be finalized in the coming months.
This also is a concern among securities industry officials.
Richard Fisher, the chairman and managing director of Morgan Stanley Group Inc., said that while the majority of derivatives activities is risk-reduction activity, some investors use derivatives to speculate on market trends.
"The enormous majority of derivatives trading is really managing risk and reducing risk rather than speculative," Fisher said at a conference hosted by the Securities Industry Association in Boca Raton, Fla. He estimated that 75% to 80% is risk management with the remaining activity being speculation.
"Sales practices are something that every firm takes seriously, and you have to be sure you are providing an investor with adequate information," Fisher said.
Zachary Snow, managing director at Salomon Brothers Inc. and chairman of the Securities Industry Association's swap and over-the-counter derivative products committee, said that even with sales practice standards in place, it would be difficult for dealers to determine if an investor is making speculative or risk management investments. Snow was also speaking at the Florida conference.
Federal Reserve Board governor Lawrence Lindsey said Friday that he saw no "systemic risk" to the financial system as a result of moves by municipalities to invest in derivatives.
In an interview on CNBC, Lindsey said, "my preference as a voter would be that my county not do that," but he stressed that it is up to the voters of Orange County do decide how to handle their money.
Lindsey said his understanding of the situation in Orange County was that the region's investment pool did "very well" during the past 15 years, enabling taxpayers to earn more on their investments than they would have otherwise. "So they have been winners; now, they have lost," he said.
Meanwhile, the Government Finance Officers Association issued a warning to its members in the wake of the Orange County revelation. The association, which represents 13,000 state and local governments, said municipalities need to "exercise extreme caution and to consider their use only when they have developed a sufficient understanding of the products and the expertise to manage them."
The association recommended that its members use the derivatives investment guidelines it released in June.
Stephen A. Davies contributed to this article.