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The Billion Dollar Gamble

How the State Invests Your Money (and What Needs to Change)

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Photo: istockphoto.com

What a difference a billion dollars makes.

Until recently, the state treasury – officially, the Treasury Management Branch of the Financial Administration Division of the Department of Budget and Finance – has operated in relative obscurity. With its staff of seven or eight employees, the treasury acts as cash manager for the state government. Its primary responsibility is to make sure the state always has enough cash reserves to meet its ongoing obligations: payroll, debt service, pension contributions, etc.

The treasury also manages the day-to-day investment of so-called excess funds: monies collected, but not yet spent, by state agencies. As it happens, that’s a lot of money – more than $3 billion at last count. Even so, these investments are hardly sexy, consisting mostly of safe, low-yield, highly liquid instruments like U.S Treasury securities, Federal Agency securities, collateralized CDs and something called SLARS, student loan auction rate securities. In other words: boring, boring, boring.

Then, in February 2008, the market for those auction rate securities collapsed. Overnight, the state’s $1 billion investment in SLARS ceased to be either safe or liquid. And suddenly, the treasury didn’t seem so boring after all.

Where the money goes

So, where did it go wrong? Georgina Kawamura, director of the Department of Budget and Finance, and the official state treasurer, describes treasury operations as a juggling act. “Here’s the day,” she says. “We get daily reports from the banks to let us know our ‘checking account’ balance. We also know, on a daily basis, what investments will mature.” These figures, combined with information about payments that will go out, constitute the calculus of the day’s excess funds, the funds available for investment. This begins yet another juggling act.

For the most part, treasury investments are scheduled to mature around large payments. Scott Kami, administrator of the Financial Administration Division (FAD), which oversees day-to-day operations of the treasury, gives the example of payday. Payroll, he says, averages about $8 million per pay period. “Normally, we schedule about half of that to mature on Friday, and the other half to mature on the following Monday. Because, historically, that’s how the checks clear.”

Armed with that information, treasury accountants can now contact brokers, banks and other financial institutions to find investment opportunities. In this way, the treasury’s responsibilities of cash management and investing are always intertwined. Every debt obligation and every dollar of excess cash must be meticulously tracked because, as Kawamura points out, “All the money is invested. All of it is earning interest.”

And yet, in a scathing report on the Department of Budget and Finance released in March, state auditor Marion Higa turns most of these mundane details on their head. For example, the treasury uses an almost indecipherable, handwritten, color-coded monthly calendar to monitor its investments. It calculates excess cash from manually prepared worksheets rather than electronic spreadsheets like Excel. And it deals with brokers through a decidedly informal system of e-mail and faxes.

Still worse, Higa says, is the treasury’s lack of oversight. The report notes that the FAD failed to prepare and review bank reconciliations, failed to produce a monthly investment report, and routinely allowed investment classes to exceed their statutory limits. In her view, it was this lax supervision that allowed the SLARS calamity. When the independent accounting firm Accuity conducted the state’s fiscal year 2008 certified annual financial report, it also said flawed internal controls led to the SLARS purchase. In her report, Higa points out that treasury staff never even saw the offering documents for these investments. Those documents clearly state many of the risks pertaining to SLARS.

The state uses a handwritten monthly calendar to monitor the
treasury’s $3 billion portfolio.

What Are SLARS?

Auction rate securities are basically debt instruments consisting of bundles of securities – in this case, student loans. The interest rates are set through periodic auctions: sellers offer securities at the lowest rate they’re willing to accept; buyers indicate the highest rate they’re willing to pay and how many they want to buy at that rate. This process is designed to determine the lowest interest rate at which all available shares of a security can be sold at par. This is called the clearing rate, and it serves as the interest rate for that entire issue of SLARS until the next auction. In the event an auction fails, the rate is set based on a pre-established relationship to some benchmark, usually the London Interbank Offered Rate, or LIBOR. Naturally, brokers assure buyers that auctions never fail.

To be fair, these auctions appeared to work efficiently for more than 20 years. And because the auctions usually happened every seven, 28 or 35 days, investors like the state treasury could treat SLARS as liquid investments, even though the underlying securities might not mature for 35 years. But sustaining that liquidity meant that all the available SLARS had to sell at every auction. That didn’t always happen, but the underwriting broker quietly bought enough to keep the auction from failing. Between auctions, brokers often tried to unload these securities on their customers.

Nevertheless, in 2007, when the financial markets began to implode, these securities began to accumulate on the wire-houses’ books, and brokers regarded them nervously. They encouraged their sales divisions to push ARS aggressively, even though insiders knew the auctions were becoming tenuous. Another sign of some distress in the market was the steady increase in interest rates, which, in the case of SLARS, eventually reached 7.35 percent (compared with 2.07 percent for two-year CDs.) For most investors, higher interest rates reflect higher risk. And yet, in the six months leading up to the market failure, the Hawaii treasury’s holdings in SLARS went from $427 million to over $1 billion, and from just 14 percent of the state’s portfolio to nearly 30 percent.

Of course, the state of Hawaii wasn’t the only investor surprised by the failure of the ARS market. Thousands of individuals and hundreds of institutional investors were caught off guard. A diverse group of government entities – states, counties, water-district boards, et al. – now found themselves stuck with these now long-term investments. Although most individual investors eventually recouped their investments through settlements with the wire houses that underwrote the auctions and government regulators, institutional investors have been obliged to write down their ARS as part of the “mark to market” standards of generally accepted accounting practices. In the summer of 2008, for example, the state acknowledged a $114 million impairment on its certified annual financial report as a result of its SLARS holdings. Though Hawaii may have the largest holdings, it hasn’t taken the worst blow. Jefferson County, Ala., is verging on bankruptcy due to the failure of the auctions.

Closer to home, Maui County found itself stuck with more than $30 million in SLARS when the market crashed. Like the state, Maui seems to have relied on assurances by a broker, in this case, Merrill Lynch, that these were highly liquid securities. Also like the state, Maui invested heavily in SLARS in the months leading up to the market failure.

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