State Government Reporting of Volatile Derivatives Needs Improvement

Published June 28, 2013

In recent years the United States has endured the worst financial and economic crisis since the Great Depression. Derivatives—complicated financial instruments whose value derives from other financial instruments—were at the center of the storm.

One of the largest insurance companies on the planet (American International Group) imploded, in large part because of its derivatives positions. AIG’s failure threatened a wide range of other entities, and a massive government bailout ensued.

But how about governments? How risky are their own derivatives positions?

Volatile Derivative Reporting

In 2008, the Governmental Accounting Standards Board (GASB) issued a statement leading to new reporting requirements for state and local government derivative positions. This statement (GASB 53) led states to begin reporting new derivative liabilities in Fiscal 2010. That year, 20 of the 50 states reported a derivative liability, while none of the 50 states reported a derivative asset.

In 2010, those 20 states reported total derivatives liabilities of $3.2 billion. Although that’s not an especially large number compared to other pressing liabilities such as those for unfunded retirement benefits, the ambiguity and discretion in valuing these positions and the potential for rapid changes in their value calls for surveillance. The case for scrutiny is bolstered in fiscally challenged states, where there may be incentives to take higher risks.

In 2011, the total derivative liabilities for these 20 states declined a bit in total, and they declined in 18 of those 20 states. In Indiana, the 2011 total was in line with 2010. Conversely, in Illinois, the reported derivative liability rose nearly 70 percent, reaching $245 million.

In contrast to 2011, the derivatives liability rose sharply in most of those 20 states in fiscal 2012. For the 19 states excepting Illinois, the total liability rose approximately 60 percent. Illinois was again the exception, but for a different reason. We have yet to learn its derivative liability at June 2012, because Illinois still hasn’t released its fiscal 2012 annual report.

Illinois’ Dubious Derivatives

States can hedge risk, as well as assume risk, in their derivative positions. Illinois may again buck the tide and this time report a smaller derivative liability for 2012 amid the sharply rising liabilities in other states. An observer’s confidence can be forgiven for being a little shaky in a state where citizens still don’t know where the government valued its derivative liability almost a year ago, for a set of financial instruments where losses can multiply quickly.

Whether derivatives are appropriate tools for state and local governments to manage financial risk is a broader topic for another day. But as long as governments are playing in that arena, citizens deserve more timely accounting and reporting than what they receive today. Quarterly or even more frequent updates on the valuation of these positions should be the norm.

In turn, Note 14 in Illinois’ 2011 annual financial report, which refers to the state’s “derivative securities,” can further undermine confidence in the state and its auditors. A small subset of derivatives can accurately be called securities, but most lie explicitly outside that realm of instruments, legally. For example, the GASB refers to “derivative instruments,” not “derivative securities,” while discussing these instruments, and actually states they should not be called “securities.”

Bill Bergman ([email protected]) is the director of research for Truth in Accounting.