Texas has instituted the most restrictive investment policies in the country, and dealers are eating dust.

By James Lacey

Four months ago the State of Texas adopted the most draconian of laws for derivatives use by public funds. The law prohibits public agencies from investing in IOs, POs and inverse floaters under any circumstances. The law also requires that municipal finance investors receive formal training on risk management techniques and that municipalities establish investment guidelines.

The most unusual requirement, however, is one requiring dealers to study the investment policies of each municipality they deal with and sign agreements asserting that their proposed instruments or strategies are appropriate. "This puts the burden of judging the suitability of investments and investment instruments on brokers," says Jerry Quinn, a spokesman for the Securities Industries Association. "And that makes Texas unique. No one has gone to the extremes that Texas did and it is causing some problems for Texas municipalities and some dealers."

Most dealers are loathe to frame and sign separate agreements with every single municipality they do business with. Most quality dealers, that is. Sleazy ones, critics of the bill have warned, will sign anything for a dollar. "Only the least reputable brokers, who don't care what they have to sign, will be out there doing business," predicts Susan Anderson, treasurer for the city of Austin. "I have heard a lot of stories that there are some dealers who have pulled out," adds Susan Horton, an officer of the Texas Municipal League. "They just don't want to review the individual investment policies of a thousand different communities."

Dealers, of course, are happy to oblige larger investors, like Texas's $14 billion "Texpool" fund or the city of Austin's $1.5 billion combined investment portfolio. But since the legislation passed, many have avoided courting the smaller municipalities. As a result, many municipalities have given up on developing individual investment initiatives, and have either begun accepting bank CD rates or putting their money in the state investment pool.

Little guys

To take some of the sting out of the legislation, Texas state officials have sat down with a half dozen of the most active dealers and tried to agree to what Austin's Anderson calls "boilerplate language for suitability certification that will be acceptable to the industry and widely used by municipalities." State Treasurer John Bell says he has talked to Rep. Kenneth Marchant, the sponsor of the bill, who is amenable to making some changes. "If language can be agreed upon that makes it possible for the firms to do business and still retain some responsibility for their actions, then we will take it to the State Attorney General for an opinion," says Bell.

But part of any deal, he cautions, would be "a commitment from all of these firms that they will use the agreed language to deal with the little guy down the street and not just the big investment pools. If they won't do that, we're not interested." Bell likes the idea of product restrictions. "Most municipal governments should have no derivatives in their portfolios," he argues. Anderson seconds this: "Local governments, for the most part, had absolutely no idea what they were buying and only did it when told by dealers that everyone else was doing it and they were losing out."

Although this could be a stopgap measure until the next legislature, the core suitability features of the legislation have strong support and are likely to remain intact. Recently, 17 treasury and cash management officials from various Texas municipalities wrote to Rep. Jack Fields, urging him to drop suitability requirements in federal legislation he's sponsoring to overhaul the securities industry (HR 2131.) They believe the language in Fields' bill gives dealers too much protection and may supersede the better protections that have been enacted in Texas.