The Billion Dollar Gamble
How the State Invests Your Money (and What Needs to Change)
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Despite the similarities between Maui and the state, there have been striking differences in how they responded to the SLARS debacle. For example, the state continues to defend its investment. “The one thing that gets lost in this whole discussion about ARS,” says Scott Kami, “is that the securities themselves are very sound investments. There hasn’t been any default on them, and we continue to get all our interest paid when it comes due.” Moreover, he says, the yield on the state’s ARS, approximately 1.9 percent, is higher than that earned by the state’s other investments. He points out the yield on 30-day CDs is almost zero.
Kawamura takes another tack. “I think people have put too much emphasis on the write-down,” she says. “Everyone thinks we’ve lost money. We have not.” She acknowledges that accounting principles required the state to estimate an impairment on its SLARS holdings. She also admits that if the state were to sell its holdings today, it would likely incur an additional $250 million loss. But Kawamura views these as purely paper losses. “That’s assuming that you’re going to sell,” she says. “Of course, we haven’t sold, and we don’t intend to.”
But Maui County treasurer Suzanne Doodan is not convinced by the state’s arguments. “I spouted those same lines for the first few months,” she says. “But these are no longer short-term instruments; you have to compare them to 30-year investments.” So, while the state’s 1.9 percent yields on SLARS may look good compared to current rates for bank repos or short-term CDs, they’re low even compared to the 4.75 percent yield on a 30-year U.S. Treasury note. SLARS might have been attractive as short-term investments, but they are liabilities as long-term investments.
This difference in perspective led Maui to pursue a different strategy than the state. This January, the Maui County filed a federal lawsuit against Merrill Lynch, the broker that sold them the SLARS. (To see Maui’s lawsuit filing, click here to download the PDF file.) Like other institutional investors around the country, Maui alleges Merrill sold SLARS as “cash equivalents” even though it knew, or should have known, these investments were unsuitable for Maui’s needs.
The state declines to discuss whether it’s pursuing legal action related to SLARS. “We’re obviously letting our attorneys take care of reviewing our options,” says Kawamura. Tung Chan, commissioner of securities at the Department of Commerce and Consumer Affairs, acknowledges receiving complaints “against these companies – Citi and Merrill – related to ARS.” DCCA policy, though, is not to disclose the name of the complainant. It remains to be seen if the state, in steadfastly defending its investment in SLARS, has lost its opportunity for legal recourse.
“I wonder if they missed the date to file,” Doodan says. “I think it’s a two-year statute of limitations.”
A Better Way
There are other important differences between Maui and the state, according to Doodan. “To my knowledge, the state has only used two brokers for years and years and years,” she says. “In contrast, we go out to at least five, six, seven, eight brokers. And every few years, we go out and solicit new brokers.” It’s also interesting, she notes, that, while Maui has suspended doing business with Merrill, the state continues to use the same broker who sold them the SLARS as bond underwriters. (This same broker, Pete Thompson, of Morgan Stanley Smith Barney, played a key role in persuading the Legislature in 1998 to add SLARS to the list of acceptable investments for the state treasury.)
There is another difference between Maui and the state. To coordinate its investments and cash-management obligations, Maui uses sophisticated, Web-based software called QED. This program was specifically designed for treasury operations and automates many basic functions of a treasury. It continuously updates the status of investments, including the current value of securities. It also provides templates for more than 600 different reports, most of which can be produced almost instantaneously. This ease of reporting simplifies the supervision and oversight of the county treasury. That’s probably why more than 40 states and thousands of counties and smaller government entities use QED.
For its part, the state relies upon a software program called Microsoft Dynamics, which is primarily a program for enterprise solutions or customer contact management. Although it has been adapted to be used for financial purposes, it doesn’t address many of the specific needs of a state treasury. As one expert put it, “This is like hunting an elephant with a shotgun.” This may help explain the treasury’s failure to routinely produce the reports called for by its own investment policies. It may also explain why the state’s investment activities are largely tracked on manual worksheets or even handwritten calendars.
Most state treasuries are far more transparent and seem to sustain much more oversight than Hawaii’s. New Mexico – an apt comparison with Hawaii because of its population of 2 million people and treasury of about $5 billion – offers an excellent model for an efficiently run treasury. “I can tell you,” says chief investment officer Sheila Duffy, “we have a lot of oversight in New Mexico. And we like it.”
Structurally, that oversight takes the form of two standing committees. The Treasury Investment Committee, Duffy says, consists of treasury officials and two securities experts from private industry. The other oversight group, the Board of Finance, supervises the broader activities of the state treasury, which corresponds roughly with Hawaii’s Department of Budget and Finance. Neither group is passive.
“We have a once-a-month report, a book really, that we deliver to the Treasury Committee” and to Board of Finance, Duffy says. This substantial report – produced automatically using QED software – summarizes the treasury’s existing investments, including asset details, yields, and trends compared to a benchmark. These reports and the minutes from committee meetings are available on the treasury’s Web site, along with numerous other reports and resources. In contrast, although Hawaii’s state treasury policy requires monthly status reports for the director of the Department of Budget and Finance, this report hasn’t been prepared since 2007, according to the state auditor. Moreover, there’s no outside authority to review such a report.
How can Hawaii improve its often informally structured, poorly supervised and cloistered state treasury? And what can we do about its extraordinary burden of SLARS?
As for the auction rate securities, the answer may be nothing. “For now, our liquidity issue is covered,” says Kawamura, by which she means that, as the treasury’s longer-term investments mature – and they’re allowed by statute to carry some investments out to five years – these are gradually replaced with the SLARS. And the state seems intent on either holding onto them until maturity – another 35 years, in some cases – or waiting until it’s possible to sell them at par. That might seem farfetched. After all, the allegations of fraud, negligence and collusion that have been leveled at the wire houses have stigmatized SLARS as an investment. But some believe the SLARS market will revive; Kami said as much in his Dec. 27 testimony at the state Legislature. Even Maui County finance director Kalbert Young holds out hope.
“I would point out,” Young says, “since the SLARS market failed in February 2008, there’s been a slow return of activity in this market.” He doesn’t mean the actual resumption of successful auctions – not yet, anyway – but that the underlying securities have started looking increasingly attractive to investors. “We’ve been getting calls from other institutions interested in buying our ARS,” he says. “Not at par, of course, but better than it was. Even Merrill Lynch was willing to purchase some.” Nevertheless, Young says, “we still want to pursue our legal filings.”
Improving Hawaii’s treasury operations may prove easier. It’s simple enough to look to the examples of other states, like New Mexico and New Jersey, that have modernized their treasuries. Software solutions typically come with extensive consulting services and are cost effective. (QED costs less than $100,000 a year, after the initial setup.) But the most important lessons probably come from history.
After the disastrous 1994 bankruptcy of Orange County, when the county treasurer’s wild, unsupervised speculation in risky derivatives cost the county over $2 billion, the California state auditor issued some familiar-sounding recommendations: Have a Board of Supervisors approve the treasury’s investment policies; appoint a committee to oversee investment decisions; require frequent, detailed reports from the treasurer; and establish stricter rules governing the selection of brokers and investment advisers.
Those sound a lot like the recommendations of the Hawaii state auditor. They’re also suspiciously close to the kinds of best practices employed in New Mexico. In other words: boring, boring, boring.
State’s mix of risky & safe, traditional investments
Cash with Fiscal Agents
U.S. Unemployment Trust
Investments Time Certificates of Deposit2
U.S. Government Securities
Student Loan Auction Rate Securities3
Total Cash and Investments
1. The state routinely failed to reconcile bank statements. In addition, funds were often left in sub-accounts that did not earn interest.
2. At least five times, the state exceeded the 50 percent limit on CDs from a single issuer.
3. The state’s portfolio of SLARS remains at roughly 30 percent of its total investments.
4. Repurchase agreements exceeded the 70 percent statutory limit in four out of 12 months.
Source: State auditor’s report
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