Greg Kaza, Executive Director, Arkansas Policy Foundation
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The federal Dodd-Frank Act (Public Law 111-203) fails to require government units using financial derivatives to publicly disclose and report their positions. The Act increased regulation of the U.S. financial services industry without enacting adequate transparency for government units using derivatives. The problem is that government units ranging from towns, cities, and counties to state retirement systems are not required to adequately disclose their use of derivatives. A double standard exists in the derivatives regulation. Private derivatives users are aggressively regulated while government units are not.
The largest municipal bankruptcy in U.S. history was caused by the speculative use of derivatives by Orange County, California officials.
In 1994, Orange County announced a $1.6 billion loss resulting in bankruptcy. Testimony before the U.S. Senate Committee on Agriculture, Nutrition and Forestry in 1998 revealed approximately 187 California government units deposited tax revenues and other public moneys in several pools, including a commingled pooled fund (the ‘County Pools’). The County Pools were managed by Robert Citron, the Orange County treasurer and totaled an estimated $7.6 billion. The treasurer used reverse repurchase agreements, a type of derivative whose purchases were based on the erroneous assumption that interest rates would remain at low levels. The treasurer also used leverage: the estimated $7.6 billion in deposits was leveraged to more than $20 billion. The treasurer’s strategy appeared to work until the Federal Reserve Open Market Committee raised the Intended Fed Funds rate six times starting in February 1994. Orange County declared bankruptcy in December 1994, and Citron later pleaded guilty to criminal charges. (http://articles.latimes.com/1995-04-28/news/ mn¬59983_1_bob-citron)
Another highly-publicized episode involves the speculative use of derivatives by government officials in Jefferson County, Alabama. The U.S. Securities and Exchange Commission has pursued enforcement actions in the episode, which involved the use of interest rate swap. The SEC charged J.P. Morgan Securities, Inc., and two of its former managing directors for their roles in an unlawful payment scheme that enabled them to win business involving municipal bond offerings and swap transactions with Jefferson County. J.P. Morgan Securities settled the SEC’s charges, paid a $25 million penalty, made a $50 million payment to Jefferson County, and forfeited more than $647 million in claimed termination fees. The SEC also charged Birmingham Mayor Larry Langford and two others for undisclosed payments to Langford related to municipal bond offerings and swap agreement transactions that he directed on behalf of Jefferson County while serving as county commission president. Langford was found guilty in October 2009 in a parallel criminal case. (http://www.sec.gov/news/press/2009/2009-232.htm)
Dodd-Frank Act fails to require government units using financial derivatives to publicly disclose and report their positions. Without transparency it is possible another Orange County-style bankruptcy could occur in the U.S.
The Orange County bankruptcy would not have occurred if derivatives transparency had been required of California government units.
The most frequent reference to derivatives at the state level is found in the Uniform Principal and Income Act, which defines the financial instruments and regulates private users. The Massachusetts Principal and Income Act (2005) defines derivatives as “a contract or financial instrument of a combination of contracts and financial instruments which gives a trust the right or obligation to participate in some or all changes in the price of a tangible or intangible asset or group of assets, or changes in a rate, an index of prices or rates, or other market indicator for an asset or a group of assets.” Massachusetts regulates the use of derivatives by state banks. A 2011 act (session law chapter 115) states “credit exposure” to “a counterparty in connection with derivative transactions shall be determined based on an amount that the bank reasonably determines under the terms of the derivative or otherwise would be its loss were the counterparty to default on that date, taking into account any netting and collateral arrangements and any guarantees or other credit enhancements.”
Michigan enacted the “Good Government Financial Report Disclosure Act” (PA 427 of 1996) after a small local unit (Independence Township) lost $2 million on domestic swaps. The Michigan law requires derivatives to be reported in an “audit report or other report for a local unit.” Units are required to disclose this information to the state treasurer or auditor general. The reports must include “the cost and fiscal year end market value of derivative instruments or products in the local unit’s pension or non-pension investment portfolio at year end reported on an aggregate basis and itemized by issuer” and type of derivative instrument or product. The Act also applies to state retirement systems and creates a depository for reports, which are subject to the state Freedom of Information Act.
Dodd-Frank regulates private derivatives users. Massachusetts regulates private derivatives users, and includes a review mechanism for government users within the treasurer’s office employing counsel with technical knowledge of the subject. Michigan provides more transparency, requiring government units to disclose their derivatives.
Massachusetts could increase transparency by requiring government units to publicly disclose their derivatives.
The costs associated with Michigan’s policy were paid for by state and local units of government out of existing budgets. Nonpartisan Michigan legislative analysts found “no costs” associated with enactment of the policy.
Initial opposition revolved around whether a problem existed, and whether transparency was required to address it. A derivatives ban was considered by some legislators. The Orange County bankruptcy increased support for derivatives transparency, and the disclosure of Independence Township’s loss led the Michigan legislature to advance the measure, which was signed into law by Governor John Engler.
The costs of reporting government derivatives use in audit or other annual reports would be paid for by state and local units out of existing budgets. There would be a modest cost if the preference was to also post all reports on government sites so individuals with knowledge of derivatives, citizens and news media could review them.
There are legitimate reasons to use financial derivatives including non-leveraged hedging. Other states responded to the Orange County bankruptcy by severely restricting the use of derivatives by government units. The Wisconsin Investment Board lost more than $95 million in leveraged derivatives linked to movements in the Mexican peso. (U.S. Senate Committee on Agriculture, Nutrition and Forestry, December 1998) Wisconsin law was amended to read, “After May 7, 1996, the board my not purchase or acquire any derivative in the state investment fund except in accordance with rules promulgated by the board (State of Wisconsin Investment Board). Rules … may not permit the purchase or acquisition of derivatives in the state investment fund unless (it) is made for the purpose of reducing risk of price changes or of interest rate or currency exchange rate fluctuations with respect to investments held by or to be held by the board.” Michigan’s policy permits the use of derivatives with the caveat that government units must be transparent.
The only legislation to date has been Michigan’s (15.422) “Good Government Financial Report Disclosure Act of 1996.”
The policy has not expanded since its inception, though the technical definition of derivatives should be updated to reflect changes in financial markets since the original measure was enacted in 1996.
Applicability to Massachusetts
Massachusetts faces the same potential problem caused by Dodd-Frank’s failure to require government units using financial derivatives to publicly disclose and report their positions, though the state has taken positive action (see below).
Other references to derivatives, in addition to those referenced above, have been incorporated in Massachusetts in the 21st century. For example, section 44 of a 2004 act further regulating the Department of Revenue states, “Section 38B of said chapter 63, as so appearing, is hereby amended by inserting after subsection (b) the following subsection:
(b ½) For the purposes of subsection (a), “securities” includes (1) equity or debt instruments and options, futures and other derivatives, that are traded on and were acquired through a public exchange or another arms length secondary market.”
Current Massachusetts practice is for the state treasurer to issue “a Request for Responses (“RFR”) from law firms or individual attorneys who specialize in legal matters pertaining to the issuance of debt” including derivatives. The treasurer seeks firms or attorneys “interested in presenting their qualifications to provide legal services related to the issuance of municipal securities by the Commonwealth of Massachusetts and Treasury Agencies.” The treasurer selects “one or more qualified Firms” from the responses “on an as needed basis to provide legal services” in areas including “Derivatives Counsel.” The Swaps/Derivatives Counsel section states, “Two Firms are expected to be selected for swaps/derivative counsel. One Firm will be primary and the other Firm will be a back-up counsel. The Treasury is seeking law firms to assist it with various derivatives transactions and with issues that may arise in connection with modifying or terminating existing derivative agreements. The legal representation may include, without limitation, the following tasks:
- Render legal opinions associated with new or amended interest rate swap or other derivatives agreements;
- Assist in the development and negotiation of new or amended ISDA contracts;
- Assist with restructurings of existing derivative agreements, including innovations, modifications, and terminations;
- Analyze and advise on federal or state legislation affecting derivative agreements;
- Assist with issues associated with terminated derivative agreements; and
- Advise Treasury on debt management and other policies.”
(Request For Responses, Legal Services Related To The Issuance Of Debt, The Treasurer and Receiver General of the Commonwealth of Massachusetts, August 31, 2011 http://www.mass.gov/treasury/docs/final-tre-bond-legal-service-rfr-august31-2011.pdf, p. 1, 23)
The author intends to work with policymakers in other states interested in requiring government units using financial derivatives to publicly disclose and report their positions. He will also continue to rely on his experience as author of the Michigan Act, and published research, to explain that the Dodd-Frank Act aggressively regulates private derivatives users while not requiring transparency for government units.
The author’s published research includes two articles for peer-reviewed academic journals:
- “A review of state statutes regulating financial derivatives in the USA.” Pensions, an International Journal, Vol. 9, Number 3, 194-202 (2004) London, U.K.: Palgrave Macmillan
- “Regulation of financial derivatives in the U.S. code.” Derivatives Use, Trading & Regulation, Vol. 11, 381-86 (2006) London, U.K.: Palgrave Macmillan
The reform requires government units to publicly disclose their use of derivative financial instruments, a requirement not included in the Dodd-Frank Act. The purpose is to prevent the speculative use of derivatives by government officials. The reform, enacted in Michigan in the mid-1990s has prevented an episode similar to Orange County, California, forced to declare bankruptcy in 1994 as the result of government officials’ speculative use of derivatives.