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.

1. Poor supervision of some state and local investment managers continues in the US. In this case it is Florida and Montana. More may be revealed. At this time, it is also unclear whether the counties and other municipalities who invested in the fund knew what the fund owned. Lawyers are going to have a field day with this one.

2. Diversification has its benefits and should be stressed in all portfolios. Florida is reported to have had 20% of its investments in this type of asset-backed commercial paper.

3. Notwithstanding all the talk of problems within municipal bond insurers, the benefits of secondary credit enhancement cannot be clearer. These are another set of eyes examining the risks in the $2 ½ trillion tax-free municipal bond market.

At Cumberland, we continue to look under the hood at bond financed projects whether they have underlying credit ratings or not. And we evaluate the credit of each bond insurer. We do NOT just rely on the rating of an agency. This doesn’t mean that one can totally avoid liquidity risk; the events of last August are indicative of that market based result. Even the highest quality bonds can experience a sloppy market. It does mean being prudent is about diversification among issuers, insurers, sectors, parts of the yield curve, and, where tax efficient, geographically.

Florida’s government and professionals are spending this weekend searching for solutions to this problem. A restructuring and some extensions of maturities can help to resolve this mess. We expect the State of Florida will have to pay the losses and make the constituent municipal entities whole.

Cumberland Advisors manages about a $½ billion of tax-free, total return, municipal bond portfolios for individual clients who reside in more than 30 states. Our internal credit standards are higher than those found in the benchmark indices. We have been doing this for nearly 35 years. In the municipal bond investing world, you do not get paid well for taking default risk. Our strategy of avoidance of payment failure has protected our clients since the days of Washington Public Power (we avoided it) and Orange County, California (we avoided it). We do not expect that any of our Florida clients will experience losses because of the Florida state pool failure.

A final irony: Orange County (FL) was an investor in the Florida pooled investment fund.

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