For decades, public entities invested operating funds almost exclusively with local banks. About 20 years ago, the picture began to change very slowly, almost imperceptibly. Public entities began investing some of their funds with other kinds of institutions for three reasons.

First, governments wanted the higher returns available from these other institutions to help them hold down taxes for state and local taxpayers, Second, they found that bank use of public funds often was dedicated to the maximization of the bank's return rather than to the benefit of the community. In essence, state and local governments discovered the concept of "float," and began to realize that they might do better elsewhere. Third, governments considered moving money out of local banks as "local" banks were fast becoming non-local as a result of mergers and acquisitions.

In an effort to maximize yields, state and local governments have broadened both the mix of investment options and the range of non-bank financial institutions to include such market makers as broker-dealers and mutual fund companies. Another wrinkle of recent years has been the arrival of the money manager who focused exclusively on short-term government operating funds - essentially overnight funds.

With custom-tailored investment programs and the kind of service that local banks once provided before being swallowed up by money center banks, money managers been making inroads into the public markets. While the evolution has been toward more variety in investments and financial institutions, the shift is not complete, and banks continue to receive a significant but declining share of the more than $750 billion that passes through state and local governments annually.

New Options, New Risks

New options always bring new and different risks. In managing investments, public investors have faced a host of obstacles, especially in the last dozen years. Against a background of relentless pressure to maintain interest income as an important budgetary revenue item, public investors have watched the markets become much more complex. The result is that state and local governments have seen investment risks multiply. For example, public deposits vanished when banks and thrifts failed. Taxpayer dollars dwindled when some broker-dealers played fast and loose in the repo markets, sometimes selling or pledging the same securities several times. Public investors neglected to check out third-party holders of collateral to be sure they could "deliver." Investment income disappeared when some public investors were overcome by the pressure to maintain a higher level of interest income and in the process absorbed unreasonable and eventually unmanageable risks. Looking forward, a significant reliance on mutual funds carries with it the risk of loss resulting from a stock market correction.

In the face of these perils, where does the public investor find a legal, safe, and productive haven for its operating funds? Already, major governmental organizations such as the National Association of State Treasurers, as well as Government Finance Officers Association, Governmental Accounting Standards Board, and National Association of State Auditors, Comptrollers and Treasurers, are re-focusing on the issues, challenges, and responsibilities of managing public funds.

At the same time, government policymakers are increasingly applying a new discipline to the investment of public funds. More and more municipal officials are calling for published, governmentally-approved investment policies. These are going well beyond the recitation of a litany of legally approved investment vehicles, incorporating, for example, rules and procedures on the ethics of public investing, due diligence procedures applicable to banks and money managers, and prudent diversification guidelines.

Within governments at all levels, the never-ending pressure to do more with less is prompting officials to examine and upgrade their cash management and investment practices. Some of the more interesting sips of change include:

* The GASB has issued pronouncements that highlight the assessment and reporting of risk in public portfolios.

* The federal government has become a real leader in promoting more efficient payment mechanisms between federal agencies and their state counterparts, while local units of government seek to expedite comparable transfer mechanisms with their states.

* Recently passed federal legislation, the Cash Management Improvement Act, has represented an across-the-board attempt to have both the states and the federal agencies analyze and expedite their own cash flows.

In a more recent development, public entities have begun to farm out their investment operations through investment in mutual funds or through the use of externally managed, customized portfolios and have increased their use of investment pools.

To give medium-sized and smaller governmental entities additional leverage and therefore more return in the investment marketplace, an increasing number of states, local government organizations, and local governments themselves have formed investment pools which are either state-sanctioned or cooperatively managed by their participants.

Investment pools provide state and local governments with the ability to maximize investment returns through the use of professional money management in the context of economies of scale. Linked services, such as improved cash management, investment accounting and reporting, expedited cash movement through custom-tailored wiring, and daily cash liquidity, all make pooled investments a true alternative to traditional bank fixed-term investments. Professionally managed investment pools are also a sensible way to deal with the greater complexity introduced by even the most common forms of derivative instruments that promise higher yields.

In addition to being more complex, some of these products have accounting anomalies. They are frequently derived from market niches that demand that investors have an ever-increasing knowledge base. Most important perhaps, derivatives make it more difficult to understand and control risk. Professional management of investment pools serves to mitigate risk while maximizing yields.

Growing Competition

In the months and years ahead, municipalities will continue to see growing competition for their investment dollar. There will be steady pressure to find yield while resisting unreasonable risk. And municipal officers will probably see new federal legislation covering supervision of investment advisors which should improve industry quality and therefore reduce the risk for public investors.

Because the public sector and its needs have become somewhat deemphasized in the overall bank business strategy, a vacuum has been created which other institutions have begun to fill with their own products and services. One of the companies which has seen this opportunity is the Municipal Bond Investors Assurance Corp. We have responded by creating products that recognize both the new and traditional needs of public investors, as well as their growing use of a wider range of financial institutions and investment vehicles.

As the nation's preeminent insurer of municipal bonds, MBIA has built its 20-year reputation on the careful assessment of risk. In recent years, we have brought that "portable" experience to public sector investment management and developed several programs designed to help manage the public purse. Our CLASS product (whose acronym stands for Cooperative Liquid Assets Securities System) is a cash management program created by a public official specifically for municipalities, school districts, and other state and local government entities.

For those municipalities that use banks as public funds depositories, we created ASSURETY - depository insurance for public funds left in banks. The MBIA surety form of guarantee is an alternative to obtaining traditional collateral. In addition, MBIA recently been to provide public sector entities with guaranteed investment agreements to accommodate intermediate-term and bond proceeds investment needs.

However, the use of non-bank options for investment purposes represents a substantive alternative to traditional bank services, not a replacement. Banks should be considered in that context and used for the many other services they can provide and do so well, such as wire transfers, checking accounts, lock-box collection arrangements, custodial services, collateral repositories, and even for fixed-term investments when they are rate advantageous.

Investment options are broader now than ever before. By exercising prudence and through the use of investment diversification, it is possible to maximize return on taxpayer dollars while protecting the public interest. The emergence of the nonbank investment alternative can provide municipalities with a new tool for the management of the public purse, a tool that should be used when appropriate and only after thoroughly analyzing the risks as well as the rewards.

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