This time, the consequences of unrealized investment losses are unlikely to spawn that kind of financial crisis, but this episode does require a rethinking of several practices in public-sector cash management — not just in California, but nationwide.
It’s a saga about how business-as-usual has backfired, so that’s where this analysis begins. Many of these arrangements are also familiar to local treasurers and cash managers outside the Golden State, including in Arizona, Colorado, Florida, Michigan, New York, Nevada, Ohio, Oregon, Texas, Virginia and Washington state.
Cities, counties and states typically invest their idle cash from tax receipts and other revenue sources in various money market instruments. Much of this is held in U.S. Treasury bills and notes and in government agency securities. By policy, they are expected to put “safety before yield,” with zero tolerance for portfolio-level losses. Sometimes these investments are limited by statute or policy to maturities of a year or less because the cash will be needed to pay bills during the budget year, but many states place no limits on maturities. So the mitigation of market- and interest-rate risk is management’s responsibility.
In governmental accounting, separate funds are established to account for money held for specific purposes such as capital projects funded by municipal bond proceeds and municipal utilities like gas, water and electricity. Over the years, a number of states and localities have set up a common internal investment pool for all these moneys; they allocate the income pro rata to the various accounting entities. It has also been popular for state and local governments to set up an intergovernmental investment pool that operates much like a mutual fund, in order to collectively optimize their returns while providing overnight liquidity similar to a money market mutual fund’s. Because these are governmental entities, the Securities and Exchange Commission does not regulate them.
In California, the state has operated one such pool for decades. Known as the Local Agency Investment Fund (LAIF), it’s the go-to place for many municipalities to park their short-term and idle cash with confidence that it can be withdrawn on short notice at par value regardless of what happens in the capital markets. For years, this state treasurer’s pool has invested in a portfolio structure with longer maturities than commercial money market funds, without concern over underwater redemptions (as explained in my April 26 column) because of dormant capital and cash reserves that will seldom or never be withdrawn. (There is a thorny upcoming June 30 reckoning, however, as explained below.)
The pooling practice has crept into the thought process of various county treasurers who operate similar investment pools for their jurisdictions’ liquid portfolios. Sometimes they also admit local agencies into their county pools, although such third-party investments are less commonplace at the county level.
Boiling the Frog
Historically, the great advantage that these treasurers have enjoyed has been the “term structure of interest rates,” which plots securities’ maturity periods against interest paid, and up-sloping yield curves, which pay higher interest on longer maturities. Over time, the logic and experience has been that the market rewards illiquidity with a higher return than if one invests only overnight on a sequential basis. Add in 40 years of declining interest rates that supercharged the realized returns on longer maturities, and these pools have thus enjoyed a multi-decade bull-market free lunch by investing as long as possible with short-term money. Disinflation was their pal.
In a world order without pesky inflation, this logic has worked fairly reliably for the treasurers managing these pools and portfolios. So over time, their average portfolio maturities crept longer. Remember the folktale about how to boil a frog? As a result, the average maturity of the California state pool is now about 310 days vs. the professional associations’ general guidelines of 90 days; six of the larger county pools have average maturities ranging from 313 to 1,000 days. For these treasurers, and those elsewhere with similar internal pooling practices, there has been comfort in the herd because peers were playing by the same strategy.
Of course, it should not go unmentioned that the broker-dealers on the other side of these trades make higher commissions on longer-maturity paper, so they had every incentive to dangle these increasingly riskier notes before yield-hungry, blindered buyers. Yet it’s not like nobody tried to warn investors that the inflation and interest rates tides had reversed. Among others, I started waving red flags last October and have revisited this escalating jeopardy. Any competent portfolio risk manager would have spotted and shrieked about the downside. Apologists who claim that no one could possibly see this coming are plainly being disingenuous.
Underwater Paper
This brings us to 2022, as inflation has worsened persistently and the Federal Reserve has initiated a series of interest rate hikes, with more to come. The market value of fixed-rate securities has correspondingly declined in direct proportion to their maturities: the longer the term, the worse the losses. As a result, these public treasurers are now stranded like cats stuck up in a tree. Collectively in California, their latest reported market-value losses were over $5 billion, ranging from 1.2 to 3.1 percent of base book value. Three-quarters of that total comes from the state and Los Angeles County pools. The entire group’s separate losses typically exceed all the investment income they each have garnered cumulatively since mid-2020. They were all “picking up pennies ahead of a steamroller.”
A sensationalist could make headlines look pretty awful with these results, but that is not my purpose here. These portfolios are indisputably underwater, but they won’t sink. While I don’t condone these treasurers for sleeping at the helm as it increasingly became evident that a market iceberg lay directly ahead, I also can’t condemn all of them. Most of these incumbents didn’t invent these strategies — they inherited them. But several did naively and imprudently pile on even more market risks last year to squeeze out a trivial fraction of interest income by locking in to even more longer-term paper that is now deeply underwater. Their staffs were complacently stuck on autopilot: They invested the public’s money into insignificantly higher-yielding longer maturities under their cash-flow models, a common practice that had usually worked for decades. Well, it usually worked — until it didn’t.
Collectively, their teams ignored the eventuality of higher “normalized” interest rates. They guilelessly bet megabillions that extraordinary monetary stimulus would persist, at least until 2024. Many failed to perform the simple market stress tests that their own professional associations advocate.
I seriously doubt that any of these pool managers will now sell at a loss, because they can quietly hold the underwater paper until maturity. If challenged, some of them may instinctively try to rationalize, save face and wallpaper over their losses. But the market’s undeniable financial scars will eventually work their way into the actual realized underperformance of their portfolios, as low-yielding longer-maturity paper remains a dead weight drag on their returns for the rest of 2022, and for several into 2023. This time, constituents and public employees will be irreversibly stuck with the tab because that revenue won’t be there. These are not victimless paper losses.
Municipalities that are now invested in California’s LAIF pool and that operate on a June 30 fiscal year will be required by accounting standards to disclose their underwater LAIF positions on their financial statements, unless they instead quickly redeem at par and reinvest elsewhere. For those savvy enough to pull the plug on LAIF, the state’s treasury must then pick up its own tab and take the heat, not them.
Public agencies that have retained external money managers whose portfolios are similarly underwater should immediately re-bid those engagements with a requirement for systematic market risk management, stress testing and loss prevention to prevent a repetition. Perhaps a competitor can demonstrate superior capabilities and diligence.
Policy Reforms and Action Steps
It’s important to gain a deeper understanding of how such investment losses can occur, and in California at least there is a venerable process: The Civil Grand Jury system can provide a proper noncriminal watchdog venue to investigate root causes, assign accountability and make recommendations for policy reforms. But while we wait for such a longer-term process to unfold in California or elsewhere, here are some constructive, forward-looking suggestions that the professional associations and policymaking bodies should consider now:
• Treasurers who operate investment pools should stress test quarterly for the price impact of major market yield shifts to enhance timely monthly reports to investors, internal auditors, risk managers and overseers. A general rule is that worst-case market price risk should never exceed the current portfolio yield. Cash-flow models alone are clearly insufficient for due diligence.
• Investment pools should not blend short-term operating cash with longer-term money. Internal pooled-portfolio managers can establish an operating cash pool that avoids losses with tighter limits on maturities to minimize interest rate risks. A separate longer-term internal pool can then hold those funds that won’t be needed for more than a year, with super-strong emphasis on stress tests.
• Bond proceeds also should be invested or pooled separately, especially where blending them with operating cash could be deemed a gimmick to circumvent federal arbitrage investment regulations by reallocating income that would otherwise be rebatable to the IRS.
• No individual instrument in a multi-jurisdictional cash pool should be purchased with a maturity exceeding two years. No more than 25 percent of such a portfolio should mature beyond one year, as New Jersey and Oregon stipulate.
One final idea specific to California: Its most-underwater treasurers should jointly retain an independent institutional risk adviser to consult quarterly with each of them about their portfolios. For a dollar or two per million, it would be the wisest taxpayer money ever spent.
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 advice.
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