Local government investment pools and the financial crisis: lessons learned.

• Author: Pantages, Jeff

Just a few years ago, everyone was grabbing for yield, and complacency reigned. In early 2007, government cash managers were being asked why they were not using the cool, sophisticated instruments the other guys were using-why they were sticking with SLY (the basics: safes liquidity, and yield) when other funds were using SIVs (structured investment vehicles). It was a world where brokers were saving their clients a few basis points by having them issue auction rate securities and swapping it to fixed instead of issuing traditional fixed rate debt.

Government investment and finance professionals were thought to be old fashioned. Of course, within months, the tables had turned. Exotic instruments were out and plain vanilla was back in style as the greatest financial crisis since the Great Depression got underway Local government investment pools (LG1Ps) did pretty well--with a few notable exceptions--and learned some lessons in the process.

HOW LGIPS WORK

LGIPs are state- or county-operated short-term investment pools that are available to cities, school districts, and other governmental entities. Authorizing statutes and enabling legislation provide structure and investment restrictions. The idea is that local governments will invest in a pool to take advantage of the economies of scale, professional management, and liquidity features that they would have difficulty achieving on their own. Participation is mandatory for some governmental entities in some states.

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Standard & Poor's estimates that there are more than 125 LGIPs. According to iMoneyNet, 45 states have LGIPs with assets totaling more than $250 billion. About two thirds of these funds hire independent money managers, and the rest are managed internally by government employees. Most operate like money market funds with a stable $1 net asset value (the NAY is the fund's per-share value, calculated by dividing the total value of all the securities in its investment portfolio by the number of fund shares outstanding) and a dollar-in, dollar-out policy. Some are ultrashort bond funds that stretch for more yield, have investment horizons from one to three years, and have fluctuating NAVs.

Importantly, LGIPs are not registered with the Securities and Exchange Commission (SEC) and are not required to register under the Investment Company Act of 1940 and meet Rule 2a-7 safety requirements like most money market funds. While many LGIPs say they are considered "2a-7-like", they generally do not meet all of the Rule 2a-7 guidelines, an exemption that allows a pool greater flexibility but also reduces investor protection. (1)

THE GATHERING STORM (2007)

The timeline of the financial crisis, shown in Exhibit 1, maps out key events against what's called the TED spread. This is the money markets' "fear gauge." It takes the London Interbank Offered Rate (LIBOR), at which banks trade unsecured funds among themselves, and subtracts the yield on risk-free U.S. Treasury bills to get a risk premium. This risk premium is normally around 50 basis points. It widened out to a record 463 basis points in October 2008, reflecting the unprecedented stress and panic in the money markets.

The financial crisis began in early 2007, when problems in subprime mortgage loans surfaced.A shadow banking system had developed, allowing banks to securitize these loans (and others) and pass them on to off-balance sheet SIVs (a type of structured credit product that borrowed money by issuing short-term securities at low interest and then lent that money at higher interest) and other investors in the United States and abroad. The problem was that this was an "originate to distribute" model, not an "originate to hold" model. There was little incentive to do good underwriting. The rating agencies slapped AAA ratings on much of this paper, relying on historical data and flawed mathematical modeling instead of common sense.

Funding for the shadow banking system came from the money markets, including money market funds and LGIPs that relied largely on the A1/P1 short-term issuer ratings from rating agencies. As the subprime crisis worsened and concerns mounted, many SIVs and issuers of asset-backed commercial paper couldn't roll over their short-term debt, leading to forced sales of the underlying assets at distressed prices. Parent banks came to the rescue in some cases, but a number of issuers defaulted.

While no 2a-7 money market fund "broke the buck" (that happened later), the SEC observed in its proposed rule for money market reform (published in the Federal Register in July 2009) that "we know of at least 44 money market...