As Ohio's state treasurer, J. Kenneth Blackwell is at the forefront of a movement to bar municipalities from investing in derivatives.
Mr. Blackwell acknowledges that the securities are useful to hedge business risk. He points out, however, that some public fund managers - under pressure to reduce taxes while maintaining services - are prone to employing risky strategies to boost the yield on their portfolios.
He says Ohio legislation he introduced in response to losses there of more than $130 million by 20 local government entities has a good chance of passing when the legislature reconvenes in November.
The following is excerpted from recent testimony to the U.S. House Banking Committee.
In light of recent losses of public funds, officials who have the responsibility for the investment of public funds must now lead in the efforts to restore the trust of our constituents in the investment of their tax dollars.
In my opinion, this leadership and the restoration of confidence can be best accomplished by public funds managers' returning to certain simple and basic investment principles.
The first principle that public funds managers must keep in mind is that we are managers of public funds. We represent the people or our jurisdictions, not Wall Street.
The needs, objectives, and strategies of private-sector investors may be completely different from the needs, objectives, and strategies of public- sector investors.
Individuals who manage the private funds of others are free to make investment decisions using that money so long as risk is disclosed.
In contrast, public funds investors are managing funds held in trust on behalf of our citizens. The purpose of this trust is not to maximize investment income, but rather to fund essential governmental services.
The public funds manager's responsibility is therefore the highest of any fiduciary standards. Public funds investors must never forget this.
Even in the investment of public funds, there are differing measures of governmental needs, objectives, and strategies. The investment needs and objectives of a cash management account are quite different from the objectives and needs of, for example, a public pension fund portfolio.
What I am speaking of is the investment of tax dollars pending their disbursement to pay for state and local obligations.
In my opinion, the investment objective and the investment strategy of a public funds cash manager must be singularly directed to the preservation of principal.
After safety, the responsibility of the manager is to maintain an optimal level of liquidity in the portfolio.
Only after safety and liquidity have been considered and implemented should the issue of yield be considered.
Recently, some public funds managers have lost touch with these investment principles.
Because the current political environment makes it difficult for public officials to make decisions to raise taxes or cut spending, investment income and aggressive investment of cash management funds are taking on increasing importance in the development of local budgets.
Local treasurers are facing increasing pressures to provide more income for the budget. This leads to riskier investments that might not have otherwise been made under the conservative principles of safety first, liquidity second, and lastly yield.
In this respect, the proper investment objective of the cash management portfolio has been lost, and once the investment objective has been lost, investment strategies have no principled foundation.
A case in point is the standard rationale for the inherent value of derivatives.
Derivative instruments are sold by market professionals as a means to reduce or eliminate an investor's exposure to market risk. However, I question the value of these strategies if in fact we hold to the traditional role of the public funds manager.
An analogy can be made between derivatives and explosives. Each has a beautiful purpose but in the wrong hands or used in ways not contemplated by the manufacturer they can and do blow people up.
Derivatives can insulate a portfolio from adverse market conditions, allowing dealers and other market makers to offer better prices, and greatly improve liquidity in the capital markets. By their selective use they allow investors to avoid unwanted risks.
However, derivatives can pose a significant threat to a portfolio if used improperly. They are marketed to provide an up-front benefit to the manager through low transaction costs, but the leverage inherent in their design subjects these instruments to large price volatility and potential losses.
Many derivative structures lie dormant until certain market events occur. Sophisticated accounting, portfolio management, and risk management systems are required to properly monitor a derivatives portfolio. Extensive derivatives knowledge is essential and cannot be viewed as a simple extension of traditional portfolio management techniques.
Investment strategies without a stated and principled objective lead public funds managers down a road without a map. This is precisely where risk, confusion, and abuse occur.
Structured notes and derivative instruments are creative and often vague instruments designed to meet specific investor's needs. Risk, confusion, and abuse are ripe to occur when market professionals sell to public funds managers based upon an investment strategy that is not grounded in a proper investment objective.
When that happens, everyone loses.
In Ohio, my office has helped draft a bill that would reform permitted investments of the cash management portfolios of local governments. Senate Bill 81 is aggressively conservative and prohibits most derivatives from use in public cash management portfolios. SB 81 not only bans derivatives in local government portfolios, but also utilizes a broad definition of derivatives in order to ensure that public cash management strategies are once again consistent with traditional objectives of investment of cash management funds.
This return to traditional roles of cash management investing might cost state and local governments money.
My answer is that public funds are held to a higher standard. Protection of taxpayer funds from the creativity of the financial engineers in the marketplace requires a broad prohibition.
Authority should be granted only after the public and perhaps the legislature have scrutinized all the risk as well as all the benefits of a proposed use.