The news of the $1.5 billion derivatives debacle in Orange County, Calif., that forced the home of Disneyland into bankruptcy last week was a little familiar. After all, in August, the Charles County government found itself on the edge of bankruptcy because a deputy treasurer had put much of the county's $33 million of operating funds into money-losing derivatives.
Is there a widespread problem with derivatives? Can other communities or investors expect to be hit by losses?
Raymond F. Devoe
Editor, the Devoe Report, Legg Mason Wood Walker Inc.
The problem in Orange County was that the treasurer was running for re-election. And his Republican opponent chastised him for taking a $6 million loss. He could not admit to any more errors, so he compounded the problem.
I guess that in dollar amounts, a good part of the damage already has been done. But many small institutions are just waking up to find they've got a problem.
The real problem is there is no counter to Wall Street. Wall Street creates the derivatives and says what they are worth. The buyer has to take it on faith. And he does because they promise high yields, sometimes 20 percent.
I don't think there should be regulation. I can't imagine an outfit less aware of what's going on than Congress. It is hard for them to know the difference between a buy and a sell.
What should be required is complete disclosure. There should be more awareness of the risks.
If someone has already bought these kinds of derivatives what can they do? Repeat after me: 'Our Father, who art in heaven . . . .'
So much depends on cash flow. If you can hold on to maturity you might possibly get out even, but then you'd still have an opportunity loss. The yields are so much lower than what you could have had.
William Reynolds
Director of fixed income, T. Rowe Price
In most of our funds there is no exposure at all. In the last 12 months we have used futures contracts to hedge against rising interest rates. Those are up to 4 to 5 percent of certain portfolios.
But that seems to us to be the appropriate use of derivatives: dampening the downside price volatility of municipal (bonds).
I think the knowledgeable and intelligent use of derivatives is appropriate in certain types of investments. It can actually reduce risk, which is why it is called hedging.
But prudent use requires knowledge of underlying investment. Some derivates are so complex that it is very difficult to truly understand what they were or how they would react. We went out and looked at Orange County's debt last year. We were uncomfortable with their investment strategy. We went out again this summer and saw the same thing. So we did not have any exposure in our money funds to Orange County bonds except we had six-tenths of one percentage point in our California bond fund.
I think there will be some sort of restrictions on derivatives investments.
Murray Levy
County Commissioner, Charles County
Each situation is different. This fellow in Orange County was evidently aware of what he was doing. He was a sophisticated investor. In our situation that was not the case. We had an unsophisticated investor who violated the law.
People here are upset. It is their tax dollars, and they want to know how this could happen. The treasurer was an elected official. She was sick, and the deputy treasurer ran off to the races. And the auditors didn't catch it.
I think there will be other communities hit by derivatives losses. The salesmen make cold calls to all the treasurers around the country -- thousands of people in little offices around the country with several million dollars to invest.
Lucille Maurer
Treasurer, State of Maryland
We manage about $1.2. billion. . . . Our return is a little better than the three-month Treasury bill, between 3.5 and 4.5 percent a year. We are very conservative.
We have never borrowed for speculation. We have no 'reverse repos.' The only thing you could call derivatives: We buy Treasury strips for lottery prizes. If you ask six people, three will say Treasury strips are not a derivative, and three will say technically, they are. As you know, those are Treasury notes in which somebody else gets the interest and we get the principal, which we buy at a lower price.
The state Joint Committee on the Management of Public Funds has prepared legislation creating guidelines that investments should match cash flow needs. That's where a lot of people are tripped up.
A lot of agencies call me up and say 'You're not doing the right investing, the 30-year bond is yielding so much more' than the short-term notes that we have, like the six-month and three-month securities. And I say 'OK, if you promise me you won't need your money for 30 years.'