Several counties employ at least one of three investment strategies we consider too risky.
These high-risk strategies include excessive concentrations of structured notes, overuse of reverse repurchase agreements, and holding too many long-term securities.
Additionally, three counties utilized agents who are also custodians to make investments that are not required to be recorded in accounting records or disclosed to participants.
County treasurers are responsible for the receipt and safekeeping of all funds belonging to their respective counties and any additional monies deposited by other participants in the counties' investment pools. However, we found that several county treasurers may employ risky investment strategies in their management of public funds. These strategies run counter to the counties' investment policies and the principles of prudent investing, namely safety, liquidity, and yield, in that order. We surveyed 57 county treasurers and found that several counties, including 7 of the 8 counties we visited, employ at least one of the three strategies that we believe can put public funds at risk. Such high-risk strategies include holding excessive concentrations of often volatile structured notes, excessively leveraging or borrowing against portfolios through reverse repurchase agreements, and investing significant proportions of portfolios in securities with longterm maturities. These strategies increase the affected portfolios' sensitivity to interest rate changes and reduce the ability of county treasurers to meet unanticipated cash needs. Also, they expose portfolio participants to increased risks.
Although the risky investment strategies we discuss in Chapter 1 were also used in Orange County, fortunately, none of these practices were taken to the extremes we found in that county. While we found that all counties we visited experienced unrealized losses to their portfolios as of March 31, 1995, these losses would not be realized unless the securities whose values had declined were sold prior to maturity. The eight treasurers from these counties stated that they had sufficient liquidity in their portfolios to preclude the sale of securities prior to maturity and, therefore, none believe that they will incur any actual losses.
Specifically, we found the following:
According to our investment experts, employing these investment strategies can be inappropriate for short-term investment pools like those used by the counties because they do not emphasize safety and liquidity over yield and expose the portfolios and their participants to increased risks.
Furthermore, some counties are using agents, who in many cases also act as the securities custodians for the same counties, to execute securities lending and/or reverse repurchase transactions on behalf of the counties. Agents acting on behalf of three counties we reviewed performed hundreds of millions of dollars worth of securities lending and reverse repurchase transactions that current regulations and guidelines fail to address. Therefore, these transactions are not reported to oversight agencies and pool participants, were not reflected in the counties' financial statements or clearly disclosed in footnotes, and were not considered by the counties when determining compliance with pertinent investment laws and county policies.
In addition, we found the following:
To improve the investment practices of local governments, we recommend that the Legislature amend the California Government Code. A few of our key recommendations are to:
To manage county investment portfolios using the basic principles of prudent investment practices, we recommend that the treasurers of the counties that employ any of the highrisk strategies do the following:
Further, those county treasurers who participate in a security lending program should do the following:
Because the counties believe we used Morningstar Mutual Funds as the basis for concluding that their respective portfolios were too risky, they disagreed with many of the findings and recommendations contained in our report. Specifically, the counties disagreed with our characterization of the counties' use of structured notes and the average length of maturity for their respective portfolios. Individual counties also raised other concerns relating to the tone and content of the report. Since we did not conclude on the counties' investment practices based on the Morningstar data as they assert, we have responded to these and other concerns raised by counties after each county's response.