WASHINGTON -- Standard & Poor's Corp. said yesterday it is stepping up its review of state and local governments' investment practices in response to the risks that rising interest rates have placed on derivative investments.
"Specific guidelines regarding portfolio diversification and procedures for investing in derivatives should be adopted by issuers," Standard & Poor's analysts said.
If an issuer's portfolio includes derivatives, the agency said it will regularly examine the book value and market value of the securities and ask treasurers why had they invested in them.
The agency said the type of derivative and its effectiveness should determine whether an issuer should exclude the instrument from its portfolio.
Exposure to derivatives need not be a cause for concern; however, for a municipality to invest a significant percentage of its portfolio in derivatives without a thorough understanding of the attendant risks is a cause for concern," the rating agency said.
Standard & Poor's said the municipal issuers that faced the most severe losses based as much as 90 percent of their portfolio on derivatives -- largely products designed to provide higher yields in the declining interest rate environment of the past several years.
With recent interest rate increases, however, those types of investments resulted in significant losses, the rating agency said.
While the rating agency has urged municipal issuers to be cautious when investing in derivatives, Securities and Exchange Commission member Richard Roberts voiced concerns over the sales practices firms use when selling derivatives to investors, which include pension funds and state and local governments.
Roberts said several purchasers whose derivative investments went sour claimed they were misled about the risk of their investments.
"As you know, a number of pooled investment vehicles have lost money this year due to what now appears to be unwise investments in derivatives," Roberts said last week in a speech before the Southern Employee Benefits' 25th annual education conference in Nashville.
Roberts said the SEC is concerned that some derivatives are being marketed more for the profit margin they provide to the securities firm than for their suitability to the customer.
"This concern only increases as the class of investors to whom derivatives are sold continues to broaden," Roberts said.
Earlier this year, SEC chairman Arthur Levitt convened a task force composed of representatives from six major securities firms to develop voluntary suitability standards for the sale of derivatives to end users, including pensions funds and local governments.
Levitt said those guidelines are expected to be released later this year.