"SLY" investing encouraged in the public sector.

• Author: Esser, Jeffrey L.
• Position: Safety, liquidity and yield

Recent losses of public funds through participation in investment pools engaged in risky practices have sparked widespread concern. The investment practices of local governments have come under intense scrutiny. Citizens are questioning their local officials. State legislators are considering more restrictive investment statutes. Individual jurisdictions are examining their portfolio holdings and are reconsidering their own investment policies. This attention to public-sector investing has highlighted the need for those officials who are entrusted with investing public funds to go back to the basics: safety, liquidity and yield (SLY), in that order.

The recent publicized investment problems can be traced to a few root causes. First, many of the reported losses were associated with investments in highly volatile instruments, known collectively as derivatives. Financial derivative products are riskier than other types of investments due to their complexity and the volatility of their market values. When evaluating derivatives, the investor must make predictions on the direction of interest rates. If the prediction is wrong, loss of principal can result. Much of the danger associated with derivative products results from the loss of market value when interest rates move rapidly. Experience now shows that such instruments expose investors to increased interest-rate and market risks.

Borrowing to increase the rate of return on investments - leveraging - also has been the cause of unprecedented losses of public funds. These losses followed earlier reports of public investors who failed to follow diversification practices and invested the majority of their portfolios in risky instruments, such as principal-only or interest-only strips.

The fallout from these publicized losses is significant. Regulators and rating agencies scrutinize debt issues, and governing bodies question finance officers closely. The loss of confidence in local government investment pools has sparked a run on pools around the country. Many state legislators have proposed, or are contemplating proposing, legislation to limit local government autonomy and investment authority. Another major problem, of course, is that investment losses translate into budget shortfalls.

The safety of public funds always has been a major concern of the Government Finance Officers Association (GFOA). The association regularly undertakes a range of activities that promote sound cash management...