WHY YOUR TOWN COULD GET STUNG LIKE ORANGE COUNTY
By RUTH SIMON ELIZABETH FENNER

(MONEY Magazine) – EXCLUSIVE

You've heard plenty about how former Orange County treasurer Robert Citron drove the county into bankruptcy by borrowing big, betting wrong on interest rates and investing billions in risky securities known as derivatives. As a result, about 180 local California governments and civic agencies are now saddled with at least $2 billion in losses, and Orange County can meet only 60% of its budget. Other localities, such as Charles County, Md. and Odessa, Texas, are suffering serious financial squeezes that have also been blamed on the use of derivatives. But reporting by Money suggests that the misuse of derivatives is merely a symptom of fundamental weaknesses in the way state and local governments invest their cash. A six-month investigation has turned up five nationwide problems: an abundance of ill-trained and overworked local investment officers; ill-conceived investment policies; a failure to accurately value investments; virtually nonexistent supervision by regulators; and widespread potential conflicts of interest.

Together, these five weaknesses raise frightening prospects for your tax dollars and also threaten the services you expect from state and local governments.

Two massive pots of money are at risk: The first is about $1 trillion in municipal operating funds and bond proceeds used to meet short-term obligations, according to Gerard Miller, president of ICMA Retirement Corp., a money-management firm. This money may be invested locally or in statewide cash pools like Orange County's $7.8 billion investment fund run by Citron. And second, another $1 trillion or so in long-term municipal investments is held in pension funds to finance the retirement of civic employees, including firefighters and teachers.

In fairness, most government investment officers do a fine job managing the dollars entrusted to them. But experts say that investment mistakes are not uncommon. "There is probably a major problem somewhere in the country every week, and it gets squashed or we don't hear about it," says George Nielsen, president of American Money Management Associates, an adviser to local governments. Here are the five key factors:

ILL-TRAINED AND OVERWORKED INVESTMENT STAFFS. Some big state pension funds, such as the California Public Employees Retirement System and the Wisconsin Retirement System, can afford a large staff of dozens of investment experts. But local investing is often handled by a finance chief who wears many hats, not all of them well. "It's often the same person who handles budget and payroll and who may send out the fire trucks," says Betsy Dotson, an assistant director of the Government Finance Officers Association, a trade group. "In a lot of smaller jurisdictions, you'll even see part-time people."

Local officials also rarely have the time or expertise needed to evaluate complex financial products, such as risky derivatives. For example, Sandusky County treasurer Virgil Swartzlander says he bought mortgage-backed derivatives between 1990 and 1993 largely on the word of the Houston-based securities dealer Government Securities Corp. Swartzlander recalls the firm promising him safe annual returns of 12% to 14%. The issues wound up losing $5.5 million of the $8 million he invested.

Last year, GSC agreed to repay the county for its losses but denied promising that the derivatives were safe. "I don't know how someone can use safe and guaranteed and l4% returns in the same breath in a 3% return environment," Frank Klaus, executive vice president of GSC told Money.

It's not too surprising that Swartzlander didn't learn more about the risks of those exotic securities. After all, for 36 years he has spent most of his time as the county's banker, collecting its real estate, personal-property, trailer and mobile-home taxes. He was handed the additional role of money manager in 1982. "I got no more staff, no more pay, no more nothing," Swartzlander says.

POORLY DESIGNED INVESTMENT POLICIES. There are no uniform guidelines as to appropriate investments or procedures for state and local investment officials; each state sets its own rules. What's more, just 5% to 10% of the nation's municipal investment policies contain the detailed guidelines needed to meet the tough standards set by the Municipal Treasurers Association. In fact, state laws often encourage risky financial strategies. Some states, including California, Michigan and Oklahoma, let local treasurers invest their cash reserves in bonds with maturities of 10 years or longer. Those securities can lose far more of their value than short-term bills or notes if interest rates rise and finance officers need to sell early to meet immediate needs.

In some places, hamstrung government managers are forced by overrestrictive guidelines to stick with poor performers. The South Carolina Retirement System, for instance, can invest only in fixed-income securities, even though most experts say stocks are a crucial component of any long-term strategy. And in Indiana and Mississippi, municipal cash funds are parked mainly in low-yielding bank products. Bank lobbyists in both states have squashed plans to let cash pools tap a broader array of higher-yielding investments. "Most local governments invest in CDs and are earning as much as 1è percentage points less than they could get from Treasury bills," says Indiana deputy treasurer Brian Burdick.

A FAILURE TO ACCURATELY VALUE INVESTMENTS AND RETURNS. Unlike mutual fund managers, many government investors aren't required to price their portfolios accurately each day-what's known as the "mark to market" procedure. Without proper pricing, emerging problems can sometimes go unnoticed until it's too late. The Securities and Exchange Commission's Richard Roberts believes the whole Orange County bankruptcy might have been avoided if Citron had been required to report at least monthly the price of his portfolio. He was able to gloss over Orange County's losses for months because he was required to report on the state of county funds just once a year. And in Texas, it's more like once a decade: The state's municipal employees' retirement fund hasn't totaled up its gains and losses since 1986.

WEAK OVERSIGHT. Government investment officials often operate with little supervision. State and local funds, in fact, are exempt from most federal securities laws. An SEC enforcement team actually looked over the Orange County books months before the bankruptcy filing. But they concluded they were powerless to intervene because Citron hadn't violated antifraud provisions of federal securities laws.

Most states have investment laws, but because government is reluctant to regulate itself, "there's no one there to police them," concedes Colorado securities chief Philip Feigin. Consider the case involving Stephen Strabala, son of the Columbiana County, Ohio treasurer, who was convicted last year of wire fraud and money laundering. Instead of making safe investments with county funds, Strabala, a former broker, lost $6.7 million on unauthorized and risky options trades. He spent another $300,000 on a condo, a Jaguar, jewelry and travel. His misconduct unraveled only after a brokerage employee began questioning the county's bank. Law-enforcement officials say the fraud could have been caught earlier if state auditors had made random checks to make sure county funds were where Strabala said they were.

POTENTIAL CONFLICTS OF INTEREST. Last year, the SEC adopted rules prohibiting municipal bond underwriters from making campaign contributions to local officials. But these rules don't bar brokers or investment advisers from donating to the campaigns of treasurers or other public money managers. Fidelity, for instance, admits that employees sometimes contribute to local races. Citron got $3,000 in campaign contributions from employees of Merrill Lynch, the brokerage that created many of the high-risk securities the county bought.

Campaign contributions aren't the only potential temptation. Last fall, federal prosecutors charged former Oklahoma deputy state treasurer Patricia Whitehead with accepting cash and other benefits worth more than $300,000 in exchange for funneling state investment business to Planners Independent Management of San Diego, her former employer. The cost to state taxpayers: an estimated $7 million in excess brokerage fees, state auditors say. Whitehead has no comment. Planners denies any impropriety and says its charges were not excessive.

WHAT MUST BE DONE

Clearly, government managers should be required to calculate the value of their holdings at least monthly. "There's no substitute," says SEC Commissioner Roberts. A government fund's current value, along with a description of its holdings and its investment strategy, should also be provided to state regulators, local officials and the public, on request.

States need to take other steps too. Many have to update their investment laws. In addition, states ought to beef up their audit procedures and tighten rules to prevent conflicts of interest. Finally, each state must ensure that someone will enforce these laws. Otherwise, you can count on reading about more Orange Countys, perhaps closer to your home.