That famous line from Casablanca describes the posturing by some local government and school officials as they look at the recent investment reports from their outsourced cash managers who have steered their treasury portfolios underwater this year. These costly managerial and oversight deficiencies are a close cousin to those described here a month ago among public treasurers whose staff-managed portfolios have lost billions in market value, but these hired guns are expected to be experts who know better. Their market losses have deepened again in the June interest-rate rout, yet in public they remain nonchalant. Something’s not right here.
Historically, most local governments managed their own cash until the idea of investment pools caught hold, first among state treasurers and then by private money managers who set up deals with a consortium of a state’s local governments in what are called local government investment pools (LGIPs). Most of these operate like a money market mutual fund. Typically, local government investors also purchased individual securities like Treasury bills, federal agency notes and bank CDs. They used the investment pools mainly for quick cash while locking in better rates on fixed-term instruments. Then, in the late 1980s, a few of the managers of LGIPs and several other small boutique outfits started to promote the idea of outsourcing cash management altogether, with customized portfolios. It caught on.
Besides successful marketing, several other factors drove the growth of outsourced cash management. First, the profits from selling government securities shriveled in the 1980s, to the point that many brokerage shops shrank their outbound sales to local governments as unprofitable. So there were fewer Wall Streeters calling local treasurers and finance directors to wine and dine them. And as I explained in that earlier column, a 40-year period of disinflation and successively lower interest rates made income from cash management an increasingly less important part of the local budget. Add to that the budget pressures on the staffs of finance departments, and it started to make sense to outsource the cash management. In some cases, the fees paid to the external manager were offline from the finance department budget, which made privatization of the function even more appealing.
Therein began what is now a cottage industry. It’s not led by the big shops like Fidelity or BlackRock but by smaller boutique money managers who cater to local governments and school districts as a primary client base.
At first, these outsourcing engagements looked a lot like the portfolios of the internal staffs, in that they were mostly short-term investments maturing in a year or less. But over time those maturities began to extend longer and longer. Adding fuel to the fire, the balance sheets of local governments had improved over the past 20 years, despite recessions and a pandemic, as they virtuously set up rainy day funds and built cash reserves to weather the economic cycles. So nationally, there are now billions in cash sloshing around in those local treasuries, yearning for ways to earn a few more pennies on the dollar. The marketing niche for outsourced money managers became irresistible.
Hiding Red Ink Behind Benchmarks
As a common business practice, these money managers often cover their tracks with “benchmarks” using an intermediate-term (one- to five-year) bond index as their comparison point for performance reporting and evaluation. They tout their ability to deliver fractional “relative performance.” Thus, if interest rates go up and the market value of their portfolios declines, it’s not their fault after all; “it’s the market.” Critics could say that this is like playing checkers while getting paid as chess masters. If you ask most members of a city council or school board how many dollars in future revenue they could forfeit in the market in any one year from their outsourced cash management, most of them would say that’s impossible. But of course, we’ve seen that belief become a fallacy in 2022 as longer portfolio maturities were overtaken by rising interest rates.
Underwater managers floundering in this sea of red ink are now touting the palliative of “peak inflation,” as if the easing of price increases will quickly wipe away their market losses. Their mantra is to “just ride this out.” But they have ignored the painful lessons of the 1970s when the inflation genie got out of the bottle. Households now expect worsening inflation, which amplifies a wage-price spiral. It’s magical thinking to expect that current interest rates can put that genie back into the bottle. Risks of rising rates remain, even if the worst of 2022’s market-price losses may already be on the books.
To add insult to injury, some of these underwater managers will be raising their fees by retracting fee discounts they instituted when interest rates were hovering near zero. Ironic, isn’t it? Why not earmark some of that growing revenue to invest in better risk management?
Local governments can’t pay their police, teachers and construction contractors next year with relative performance. So let’s focus only on where portfolio market losses are worst, income remains materially impaired and risks are opaque. Clients of external managers whose portfolio maturities average less than 200 days can keep sleeping soundly while we focus here on portfolios with the most red ink.
Introducing the Patch
With all that in mind, my previous column proposed that those public agencies which have recently experienced serious losses in market value from their outsourced portfolios should immediately re-bid those engagements to begin requiring stronger risk management, risk reporting, market-stress testing and client oversight. But nobody provides a how-to road map. Staff-level procurement personnel lack experience in this arcane field, and most have no idea where to begin in drafting such RFP terminology. So I took the time to work up some common-sense technical provisions that can be adapted as amendments to these outsourced money management agreements. Call it a “patch,” similar to a software patch that’s applied when a malevolent computer virus is detected. Whether it takes a re-bid or the threat thereof, or if the industry leaders will honorably stand up and finally do the right thing for their clientele by proactively putting these provisions into their standard agreements, a patch is now clearly overdue.
Amending an investment management agreement is simple, once the client’s terms are established: Regulators require that these contracts all contain a clause giving the client the right to cancel on very short notice, so the leverage here is in the hands of the public-sector client. Here is prototypical language for at-risk outsourcing engagements, typically those with average maturities over 200 days:
• The external manager will retain on its staff a trained, non-conflicted portfolio risk manager whose foremost function is to identify security and portfolio risks that could result in negative 12-month total returns (or a client-specified dollar limit) on a mark-to-market basis. The risk manager shall not be assigned to or compensated for increasing assets under management, responsible for securities selection or engaged in routine trading activity, and shall be a credentialed professional approved by the client.
• The risk manager shall have clearly specified authority to block purchases and order liquidation of securities to constrain risks under adverse or inauspicious market conditions.
• The firm will issue quarterly market stress test reports to the client that provide specific portfolio-level scenario outcomes of two types. One of them would plot the cumulative impact of a one- or two-point upward shift in the yield curve — changes in the interest rates — for securities over a six-month holding period. The other would provide the same scenario outcomes modeled on the 1994, 2004 and 2022 Federal Reserve tightening cycles. These reports shall be distributed directly to the agency’s chief finance officer, risk manager and internal auditor, with explanatory commentary and client-specific market-loss risk assessment. (Correspondingly, the major professional associations should provide training to internal staff on these basics of portfolio-level market stress-testing, for both internal and externally managed portfolios.)
• The firm will immediately notify the client when portfolio market value shortfalls from book exceed or expand by 50 basis points in the most recent trailing three-month period.
• The firm will meet with the client staff, senior management and oversight officials including internal auditors and finance committee chairpersons at least annually to discuss its risk management policies, staffing, procedures/protocols and recommendations to strengthen portfolio risk and loss controls.
Of course, none of these measures will undo the damage already done to portfolios this year. Defenders of the status quo will claim that the horse is already out of the barn, that black swans — unpredictable financial events with severe consequences — don’t return. Undoubtedly, they will assert, there will come a day when inflation subsides, allowing interest rates to normalize. But inflation is obviously not yet contained, and the Fed is clearly not done tightening.
Nobody wants to be a general fighting the last war, but what elected official would not want to know the downside of their outsourced cash management program? What finance officer, internal auditor or risk manager doesn’t want to know in advance how badly higher interest rates and more market losses would impair their 2023 interest income? After all, this is not rocket science, and the cost benefit is clear. A tighter leash on outsourced cash managers simply avoids future mutual embarrassments and reminds everybody whose cash is on the line.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be considered investment or legal advice.
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