GFOA's new model investment policy.

• Author: Saddler, Michelle R.B.

Since the first edition of GFOA's Investing Public Funds, "investment policy" has become a commonly used term of art in state and local government. An investment policy is a set of guidelines used by public agencies and others to prudently manage their investments. A disquieting history of losses in the public funds arena--and a strong sense of foresight--motivated author Girard Miller and GFOA's Committee on Cash Management to first develop guidance for government finance officers charged with investing their communities' financial assets.

Investing Public Funds provided the first known "sample" investment policy for government investors. In response to a series of high-profile investment losses in the government sector during the 1990s, the sample policy was developed into a "model" policy. As more states have adopted mandatory requirements for investment policies at the local level, the result unfortunately has been a proliferation of identical policies that may or may not be understood by key constituents. Further, despite the guidance of the sample policy, governments have continued to experience investment losses. In an effort to make policies more germane to the limitations and tolerance levels of individual units of government, the Committee on Cash Management recently revised the model investment policy.

This article will review the need for investment policies and discuss why the earlier version of the model investment policy warranted revision. The article will provide an overview of GFOA's revised model investment policy and will highlight the major differences between the two versions. Finally, the article will offer guidance on how to use the new model policy to either develop an investment policy for the first time or revise an existing policy.

WHY INVESTMENT POLICIES? AN HISTORICAL PERSPECTIVE

Despite the best of intentions and efforts, investment losses do happen from time to time in the public sector. Although these losses can be devastating to the governments and individuals involved, the lessons learned from their mistakes are of great value to the rest of us. For example, the lessons of the 1980s and 1990s prompted government investors to develop policies and procedures by which they can better safeguard public funds. Many practitioners have since adopted the mantra of Will Rogers: "I am more concerned about the return of my principal than the return on my principal."

The following sections highlight some of the high-profile investment losses in the public sector over the last two decades, as well as the lessons learned from these unfortunate mistakes. It should be noted that most of the entities identified here have since adopted strong investment policies and procedures. In fact, some of these entities are now leading the way in safeguarding public funds.

Lessons from the 1980s. In 1982, an agency in the State of New York invested $305 million (60 percent of its portfolio) in repurchase agreements with Lombard Wall, a brokerage firm that had filed for Chapter 11 bankruptcy. This agency lost $21 million when the repurchase agreements were considered merely collateralized loans.

In March 1985, the bankruptcy of ESM Government Securities caused municipal investment losses of approximately $100 million. In most of these cases, the losses were a result of governments investing in repurchase agreements and other instruments without taking delivery of the collateral instruments. In the end, nine government entities in seven different states suffered investment losses averaging nearly $11 million each. After lengthy disputes and litigation, these municipalities were able to recover only 60 cents on the dollar. On a positive note, the City of Tempe, Arizona, which had taken delivery of its investments with ESM, neither suffered a loss nor saw its assets tied up in legal proceedings.

Improper brokerage selection and failure to take delivery of collateral instruments took a heavy toll on the public investment community during the 1980s. A case of price gouging in one Ohio county only added to the woes. But these incidents ultimately galvanized the profession and led to the widespread adoption of a number of remedies, including the use of delivery versus payment, improved broker/dealer selection and agreements, the development and use of master repurchase agreements, and competitive bidding for investments.

Lessons from the 1990s. In the 1990s, investment losses stemmed not from relying on less creditworthy trading partners or failing to properly secure investments, but rather from unsuitable investment instruments and the leveraging of public funds. These...