In Hawaii, an Imbroglio Over an Investment Gone Bad

Just as the economy was beginning its nosedive, the state of Hawaii doubled down on its investment in an exotic financial instrument known as auction-rate securities. Between July 2007 and February 2008, the state’s holdings in these investments more than doubled, from $427 million to nearly $1.1 billion.

At the time, it seemed like a safe bet. Many other institutional investors, including other state and local governments, had placed their money in these long-term, high-yield securities.

Then, things went wrong. In the spring of 2008, the market for auction-rate securities froze up, and the regular dividends that had made the investments an attractive place to park cash stopped being paid. Hawaii, which was among the most heavily invested in the securities, is now left with the one-third of its more than $3 billion treasury locked up in 30-year investments that are essentially illiquid.

Nobody in Hawaii disputes that the investment didn’t go as planned. The state already has written down the value of the securities by $250 million.  What’s less clear — and is one of the hottest political debates in Honolulu at the moment — is how big of a problem this represents.

Marion Higa, the state’s longtime auditor, thinks it’s a crisis. In March, she issued a report faulting Hawaii’s Department of Budget and Finance for prioritizing investment yield above safety. She says buying  the securities, which were backed by long-term student loans, violated a law requiring investments to mature within five years. According to the report, the department suffered from a “lack of proper leadership and accountability.”

Linda Lingle, Hawaii’s Republican governor, has been firing back, both at the report and at the auditor herself. Calling Higa’s report “the shoddiest work I’ve seen,” Lingle called for an investigation into the auditor’s office. Budget chief Georgina Kawamura has testified that Hawaii had a decade’s worth of experience with investing in auction-rate securities and the bonds were rated AAA.

Meanwhile, the state Legislature is launching its own probe into the affair. Legislators have formed a joint investigative committee — with full subpoena powers — to look into the state’s money management policies. As the attacks between Lingle and Higa escalated this spring, it’s left many observers in the capital scratching their heads. “The bottom line: Either Linda Lingle or Marion Higa is lying,” the Honolulu Advertiser wrote in an editorial. “And we the taxpayers are stuck trying to figure out which it is.”

Recession in the islands

The mud-slinging over Hawaii’s finances comes at a time when the island nation’s economy has been battered especially hard by the recession. Tourism, Hawaii’s leading industry, took a big hit from 2007 to 2009, with visits from the U.S. mainland down 15 percent and visits from Japan off nearly 20 percent. This year, Lingle and the Legislature had a $1.3 billion deficit in its $10 billion budget to contend with, which they balanced by furloughing state workers and teachers, cutting 800 jobs, raising taxes and delaying tax refunds.

Lately, the economic picture has been looking up. The latest economic forecast from the University of Hawaii Economic Research Organization predicts that tourism is due for a rebound this year and next year. “Hawaii’s economic recovery has begun,” the report says. “Employment is stabilizing, and many sectors will begin to add modest numbers of jobs as the year progresses.”

Still, just before the firestorm over Higa’s audit hit, the credit-rating agency Moody’s changed its outlook on Hawaii’s outstanding debt from stable to negative. Lingle publicly worried that the audit would further threaten the state’s credit rating and its reputation with investors. Carl Bonham, an economics professor at the University of Hawaii, says there’s good reason to be worried. “If you’ve got money you can’t get out, you’ve lost something,” Bonham says. “Flexibility is a good thing when you have a billion-dollar deficit.”

Lingle has criticized Higa for implying that the money tied up in auction-rate securities could otherwise have been returned to taxpayers. “Her recent point that they could be used for tax refunds is just ridiculous,” Lingle said, according to the Honolulu Star Bulletin .

“Anyone with any knowledge of state finances would have known that. Auction rate securities are not general-fund revenue. It is not extra cash laying around. It is money in the airport fund set aside for particular projects.”

Higa, who the Legislature has approved to a third 8-year term as auditor, stands by her report. “I’ve served with three governors in office, and it’s always contentious,” she says. “This one turned personal at a much higher level from the very beginning and I’m not sure exactly why.”

The audit is an investigation into bureaucratic and fiscal management and it plainly states that, in the auditors’ opinions, the department broke policy and law. The state attorney general, however, has issued an opinion that no laws were broken.

Hawaii isn’t the only state to have invested in auction-rate securities. And the instruments, in and of themselves, aren’t necessarily bad, says Bart Hildreth, a public finance professor in the Andrew Young School of Policy Studies at Georgia State University in Atlanta. Ultimately, though, they failed as the market dried up, leaving investors in a precarious financial situation.

Still, Hildreth says, Hawaii’s position is unusual, given the composition of its investments and how much of the state’s funds were in this one particular instrument. But the drive for high-yield investments has driven many other public money managers to similar moves, and Hawaii is simply the latest to suffer through the downside when things don’t work out as planned. “It’s a recurring thing, that pendulum swings,” Hildreth says. “In my 30 years-plus of watching all this, I’ve seen several cycles of state and local governments, as investors, going overboard.”

But long term, Hildrath says, if the state is able to hold onto the investments and not have a run on its resources, eventually the investments should mature and Hawaii will get the return it was looking for in the first place. The question is, whether it can afford to wait.