Washington area governments safeguard their investments in a way that would seem to preclude the losses suffered by a number of municipalities around the country when the securities firm they did business with collapsed earlier this month.
A survey of area investment officials revealed that many local governments and pensions routinely make complex, short-term loans to securities dealers and take government securities as collateral. The transactions are called repurchase agreements and reverse repurchase agreements.
They are in reality short-term loans -- in which a party with cash lends the funds briefly and takes government securities as collateral. The party receiving the cash agrees to buy back the securities at a higher price later.
The local governments that were hit when the Florida securities dealer collapsed had left the collateral with the dealer, believing it was safe there. None of the local governments involved was from the Washington area.
Local jurisdictions that engage in repurchase agreements never leave the collateral with the dealer, officials said. They always demand the securities before making the loan.
"It would be too dangerous not to take possession. It would be crazy not to do it that way," said Edward Barnette, short-term cash manager for Fairfax County.
District of Columbia Controller N. Anthony Calhoun said that, on any given day, the District government may have between $30 million and $200 million in cash. It invests some of that cash in repurchase agreements with dealers, but always requires the dealer to deliver the securities to a designated custodial account at a bank before the District delivers the money. Because the District's profit comes from selling the securities back at a higher price than it purchases them for, the District requires that the value of the collateral exceed the value of the loan -- a "haircut" in financial parlance.
Officials of the State of Maryland, Montgomery County and Prince George's County follow procedures similar to those followed in Washington.
Edwin J. Schamel, chief deputy treasurer of the State of Maryland, said the state has an average of $75 million to $100 million each day to invest. Like most other jurisdictions, it places those funds in a variety of investments, including Treasury bills and notes, bank certificates of deposit and repurchase agreements. "Our first priority is capital preservation, because it's not our money, it's the public's," Schamel said.
Virginia law requires municipalities and pension funds to take possession of collateral and the municipalities and pension funds all require that the collateral be worth more than the loan.
Ernest Mazin, an administrator in the Arlington Retirement Office that oversees the county's pension funds, said the pension funds invest in government securities but do not engage in repurchase or reverse repurchase agreements. "Those are short-term," Mazin said. "We are looking at the long term."
About a dozen municipalities, including Beaumont, Tex., and Toledo, Ohio, along with five savings and loan associations, had their securities at E.S.M. Government Securities Inc., the Florida securities dealer with which they did business.
When E.S.M. was forced into bankruptcy early this month, the municipalities and the savings and loans swallowed losses that may reach $300 million. E.S.M., which had been concealing losses for nearly a decade, didn't have all the securities it said it had. In some cases, the firm used the same security as collateral for two separate loans. In other cases the firm apparently sold securities it was supposed to be holding as collateral or delivered them to lenders that demanded physical possession. Home State Savings Bank, a Cincinnati savings and loan association, had bought hundreds of millions of securities through E.S.M., and when E.S.M. was closed, a lot of those securities weren't there. Home State's losses could approach $150 million.
Depositors at Home State -- a state-chartered institution and privately insured -- started a run on the thrift institution that ultimately led to its closing. Within days depositors started a run on the 70 other privately insured savings institutions when they realized Home State's losses could wipe out the private insurance fund.
To stop the run, the other institutions were shut last Friday and remain closed, although state and federal regulators are moving to reopen as many of them as they can, under the umbrella of federal deposit insurance.
Every day, tens of billions of dollars of short-term investments that use government securities as collateral are carried out in the loosely linked government securities market. The 36 or so biggest dealers, those that do business daily with the Federal Reserve, must meet tough capital and auditing standards -- as must non-Fed dealers that are banks or securities firms. But a large number of dealers, like E.S.M., are not regulated by anyone.
In the last few years, at least five such dealers have collapsed. E.S.M.'s losses may be the biggest. The losses nearly always revolve around repurchase agreements and reverse repurchase agreements.
In a repurchase agreement, an investor with spare cash buys the securities for a specified length of time and sells them back to the original owner at a slightly higher price. The difference between the purchase price and the repurchase price is profit to the investor with the cash. In a reverse repurchase, the owner of the securities sells them and agrees to buy them back.
It is the securities dealer that generally is on the other side of either repurchase agreements or reverse repurchase agreements. Local governments with spare cash loan the dealer money. Savings and loan associations that need to raise cash temporarily sell their securities and agree to buy them back.