Northern Rock has a branch in Tallahassee

Author: David Kotok, Post Date: December 1, 2007

Runs on financial institutions are not always seen as lines forming in front of banks. The State of Florida has suspended withdrawals from a state operated pooled investment fund. The fund was designed to benefit Florida’s counties, cities and school districts by pooling and investing their short term funds for them. The suspension occurred just days after Florida officials said that their Local Government Investment Poll was safe.

State sponsored pooled funds are commonly used around the country. They are supervised by the states; their governing rules are usually made by the legislatures. They usually do NOT have federal government support or access to the Federal Reserve. In normal times, they provide economies of scale and convenience for municipal entities and allow for short term fund investments until they are needed for payments, payrolls, debt service, etc.

Florida’s fund has been hurt by some commercial paper of financial companies that had invested in subprime mortgages and subsequently been downgraded to default status. Thus, being one step removed did not prevent a “run” on the pooled fund. The pool had $10 billion in withdrawals in just two weeks. It is down to about $15 billion in size. This has shocked all the municipal subdivisions that invested in the fund. It is impacting payrolls in certain school districts. Many municipal entities were pulling their money out of the fund until Florida halted withdrawals. The fund was once as large as $42 billion. It appears there will be losses taken on some of the fund’s remaining investments.

In Montana, there was similar news as school districts, cities, and counties pulled out $247 million from the state’s $2.4 billion investment pool. The trigger was a revelation that one of the pool’s holdings was lowered to default status. So far we have not heard that Montana has halted withdrawals.

At Cumberland, we expect that every state and municipal pooled vehicle will now be scrutinized by the respective state officials. Furthermore, many municipal entities will simply seek immediate safety by pulling their money out of pools and return to collateralized bank deposits. We see that among our municipal consulting clients.

Some readers may not know that Cumberland has a division which consults for state and local government entities. We advise them on their $millions of investments vehicles. In that division we constantly are reviewing our client’s investments. Part of that process is the examination of the content and structure of these pools. If the pool is not fully transparent, we avoid it.

When this Florida and Montana news broke it brought to mind the debacle of Orange County, California in 1994. In that episode, Orange County, one of the wealthiest counties in the country, ended up filing for bankruptcy. It quickly lost its AA- rating. Orange County had pursued a risky strategy of investing in inverse floaters. That involved putting up bonds the county owned as collateral to buy more bonds. The county fund essentially leveraged itself by betting that the bonds they were buying would yield more than their borrowing costs. That strategy blew up in 1994 when the Fed raised short term rates and long term rates followed upward. Schools and cities in Orange County had used the fund for short term investments much like municipalities do/did in Florida. The State of California eventually restructured the fund and liabilities were eventually paid but the period was tortuous for the bond markets as well as the municipalities.

Three things become evident here.

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