DALLAS -- Eight Texas universities and junior colleges have one-third to all of their portfolios invested in derivatives -- rated most highly volatile -- and could face financial difficulties in the future, according to a state auditor's report released yesterday.
"The high concentration of volatile mortgage derivatives in investment portfolios creates the risk that future liquidity problems could occur," the report said.
"Derivatives held by six universities and two junior colleges in Texas have market values ranging from 34 percent to over 50 percent less than book value at July 31, 1994," the report continued.
The report follows a nationwide controversy over derivative products and a financial crisis in Orange County, Calif., which was forced this month to file for Chapter 9 municipal bankruptcy reorganization.
In Texas, the auditor's survey of almost 300 state agencies, universities, and colleges was precipitated by a financial crisis at Odessa Junior College, which invested 100% of its portfolio and operating capital in risky derivatives.
The auditor's report shows that the Odessa Junior College situation was the most serious -- the market value of its portfolio had dropped to $10 million or less than half of its book value as of July 31. But Odessa was far from being the only university or college to be hooked by the promise of high yields from risky derivatives and harmed by the failure to follow sound investment policies.
In addition to Odessa, four Texas universities had more than 60% of their investments in mortgage derivatives, which have been pounded this year as interest rates soared.
As of July 31, the four universities and their percentage investment in derivatives are: University of North Texas Health Science Center, 86% of a $12 million portfolio; Midwestern State University, 84% of a $12 million portfolio; East Texas State University, 79% of a $21 million portfolio; and South-west Texas State University, 62% of a $55 million portfolio.
Two other universities and one other junior college also showed high percentages of derivatives investments, according to the auditor's report. They are: Sul Ross State University, 44% of a $9 million portfolio; Amarillo College, 44% of a $10 million portfolio; and Texas Woman's University, 35% of a $30 million portfolio.
"The majority of the mortgage derivatives held by the six universities and two junior colleges are considered speculative based on criteria established by Fitch Investors Service..." the auditor's report said.
On a Fitch rating scale of 1 to 10, most of the derivative investments carried the high to speculative market risk rating of 8 through 10.
Fitch senior director Glenn Costello said many investments are collateralized mortgage obligations that had extended maturities of 25 years, in some cases. The eight universities and colleges invested in a variety of mortgage-backed derivative products ranging from inverse floaters to interest-only strips and principal-only strips.
Most are now difficult to sell or would have to be sold at a substantial loss. "A lot of exotic securities are highly illiquid and trying to find a buyer for them is difficult," Costello said.
All eight institutions say now they will not be forced to sell the securities at a loss.
"Everyone has responded that they think they can manage without selling," said Sharon Cobb, first assistant state auditor. "They tell us they will be okay and they can manage the situation right now."
Several of the eight colleges and universities had some operating funds in derivatives, Cobb said.
"There are potential liquidity problems ... but we don't expect an Orange County because we are not leveraging or borrowing," except for Odessa Junior College, Cobb said.
The report said potential liquidity problems are mitigated by the fact that appropriations, tuition, and fees are deposited in the state treasury.
In addition to the eight colleges and universities, more than 16 other state organizations surveyed by the auditor's office have investments in derivatives.
The report said total derivative investments of the entities surveyed account for less than 10%, or $6.5 billion, of their total investments of $74.6 billion. More than 92% of the derivatives, or about $6 billion, are in the state's largest portfolios, which include the Texas Education Agency and The University of Texas system.
"A significant portion of these investments are held by pension and endowment funds, which are long-term in nature," state auditor Lawrence Alwin wrote in a letter yesterday to the members of the Texas Legislative Audit Committee, which requested the report. "The level of investment in derivatives at these entities appears reasonable."
The report said the those entities had derivatives that accounted for 1% to 33% of the portfolios, substantially less than the universities and colleges identified with potential liquidity problems.
"Inadequate diversification of investment portfolios increases the risk that liquidity problems could occur," the report said.
It attributed problems at the eight institutions to three factors:
* Lack of good management controls over the investing function. "Oversight by board members and senior management and the monitoring function have not worked effectively," the report said.
* Investment staff's heavy reliance on brokers and dealers in making investment decisions. "Some institutions, especially those with smaller portfolios, may not attract the level of expertise needed to manage a portfolio with complex investment instruments, such as derivatives," the report said.
* Pressure on investment staff to produce more income as colleges, universities, and state agencies are asked to work with more limited budgets.
To prevent poor investments in the future, the state auditor's office makes several recommendations, including:
* Development of investment policies by agency and university boards. That would include monitoring of transactions, portfolio mixes, and risk levels.
* Training of investment staff to make decisions associated with complex financial instruments such as derivatives. In addition, board members and senior management should obtain training on investment controls and potential liability of investments.
* Asking the state legislature to tighten the Public Funds Investment Act to help establish management controls and require annual compliance audits.
* Asking the lawmakers to develop restrictions on the types of allowable investments.
Cindy Rugeley, press secretary for Lieut. Gov. Bob Bullock, said state leaders were putting together a working group to recommend legislation to deal with the derivatives problem.
She said the appointments should be made in the near future and legislation would be introduced in the upcoming Texas Legislative session, which opens Jan. 10.
The legislation is expected to call for adequate disclosure and uniform reporting of investments and possibly to limit the percentage of derivatives in the state's portfolio.
Meantime, she said Bullock and his staff don't see a situation similar to Odessa, which needed to sell debt, raise tuition, and take other emergency measures to stay afloat when it tied up operating capital in volatile derivatives.
The other colleges and universities, she said, "are liquid enough to maintain their day-to-day operations."
In responses provided to the state auditor's office in early December, the eight Texas universities and colleges with high concentrations of derivatives said they would not be forced to sell the securities at a loss.
All said they had an adequate cushion, although several industry sources said some of those organizations could be forced to raise more revenue or curtail costs to cope with the financial pinch triggered by the derivative investments.
In a Dec. 2 letter to auditor Alwin, the University of North Texas Health Science Center at For Worth indicates that its heavy investment in derivatives will not precipitate a crisis.
"The health science center has not had nor do we anticipate any cash flow problems," wrote Mike Ferguson, vice president for fiscal and administrative affairs. "A cash trend analysis over the past five years (ending Aug. 31, 1994) shows that the institution has increased locally held cash and investment balances from $8.9 million to $12.6 million."
In addition, several of the eight respondents said they would implement more stringent controls on investments in the future.
Eastern Texas State University officials told the auditor's office that the university hired a Houston financial adviser to assist them in the management of their investment portfolio and that they plans to tighten investment procedures.
"Like many other investors, we didn't realize the possible downside to derivatives until the Federal Reserve began taking the unprecedented action of raising interest rates six times during the last eleven months," university president Jerry Morris wrote in a Dec. 2, memorandum. "We honestly thought we were being conservative as far as risk was concerned."
In part, the colleges and universities said the higher yields of the derivatives were appealing because pressure exists to get higher returns on investments.
"We agree that pressures have existed on investment people to produce as much income as possible through investments," said Midwestern State University president Louis J. Rodriquez in a Dec. 1 letter to the auditor's office. "I believe this can be attributed to the fact that the state is continually diminishing its support of higher education, and we are all seeking other sources of revenue."
[TABULAR DATA OMITTED]