State board stops investing in derivatives

Madison, Wis. In the wake of a $95 million loss, portfolio managers at the State of Wisconsin Investment Board have been ordered not to make any new investments in derivatives until an accounting review is completed.

And the investment board employee who made the risky derivative investments no longer is involved in managing the State Investment Fund, said Patricia Lipton, the investment board's executive director.

"We've asked all portfolio managers to cease and desist when it comes to any kind of derivative activity," Lipton said.

Any derivatives transactions now must be approved by Lipton or the investment board's general counsel, she said.

Derivatives are securities whose value is derived from other securities. Derivatives are considered more risky investments because potential losses are virtually unlimited.

Lipton testified Wednesday before the Legislature's budget-writing Joint Finance Committee, at a previously scheduled hearing on the governor's recommended budget for the investment board.

Last week, the investment board announced a $95 million loss, $60 million of which was linked to investments in the Mexican peso. The peso's value began falling in December, and since has plummeted by about 50%.

The losses occurred in the investment board's $6.7 billion short-term cash-management account for state pensioners and municipalities.

The fund has had no "significant" withdrawals, and investor cash flows are normal, Lipton said.

The fund's losses will be spread over 5 to 10 years, with an impact of about $1 million a year, Lipton said.

Lipton did not name the Mexican investments involved in the losses, but she discussed one of the transactions that was eliminated from the portfolio.

"The benefit to us was determined by how the spread between the Mexican interest rates performed relative to US Treasury rates," Lipton said. "The position moved against us."

Lipton called this and other transactions "inapplicable and inappropriate for the State of Wisconsin Investment Board."

While the Mexican investments were eliminated, others were "neutralized" with so-called mirror swaps, Lipton said. In a swap agreement, investors agree to exchange the cash flow stemming from one security for the cash flow of another.

The accounting firm of Price Waterhouse should complete its review of the board's investments by the end of March, Lipton said. She hopes to make the report available to legislators in early April.

In related developments, six legislators are calling for either an audit or public hearing about the investment board's derivative investments. Also, Sen. Alberta Darling (R-River Hills), chairman of the Senate Financial Institutions Committee, announced that her panel would investigate the investment board's loss. A hearing is scheduled for Wednesday in Madison.

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