WASHINGTON - The Orange County, Calif., derivatives debacle is just another manifestation of a problem that has been the surface of the municipal market for some time.
The roots of the problem are an almost drunken lust for higher investment return by some states and localities and greater profits by securities dealers.
All local governments have been under tremendous pressure over the last few years to find new revenues to offset increasing costs and to make up for lost tax revenues.
While numerous states require localities to invest their spare cash in conservative instruments, some, like California, have eased their laws to allow the use of derivatives and leveraged investments. That has in certain cases sent finance officers, including those who have only a scant knowledge of the risks of derivatives, scurrying off to find high-yielding investments.
Such investments have been ripe for the picking, because a number of dealers have been aggressively marketing derivatives to states and localities, apparently without always disclosing the associated risks or asking themselves if these products are really in the best interests of their clients. That policy has produced an explosive situation that is likely to become more charged as further losses from derivatives activities come to light.
Some governments that were very cocky about putting their spare cash into speculative investments have sued dealers when the investments turned sour, and more suits are likely in the wake of the Orange County mess. But dealers, some of which critics charge have shown little regard for whether the instruments they sell violate state and local government investment laws or guidelines, are arguing that most government clients are sophisticated and thus the dealers should not be held liable for losses.
Some of those issues have already surfaced in a case in West Virginia that involves risky transactions in government securities and has broad implications for dealers.
In that case, a county court found that Morgan Stanley & Co. had engaged in illegal, speculative government securities transactions with the state, and ruled that the firm should be held liable for $30 million in losses.
But the Public Securities Association, in a brief filed with a state appeals court that is to hear Morgan Stanley's challenge to the decision on Jan. 18, has charged that the decision improperly shifts responsibility for losses to dealers and makes them "insurers" of profit for clients.
The outcome of that case, which is likely to end up in the Supreme Court, may eventually draw an important legal line for dealers and government investors.
Before that happens, however, dealers should apply some overdue self-restraint and accept the same responsibility in selling derivatives that a tavern keeper has in selling liquor.
The customer should know when to quit. If he doesn't, the dealer shouldn't serve him another drink. It might only send him out onto the highway to kill himself or someone else.
