How does the average Idahoan make sense of recent media reports that the treasurer's office lost millions of taxpayer dollars in a complex financial transaction five years ago? It's a tough pill to swallow for every stakeholder. But more important, what exactly happened, what did we learn from it, and how can it be prevented in the future?
The private-issue, nongovernment, mortgage-backed security, as described in the State of Idaho Internal Control Report, was ubiquitous during this time period. You may recall that the practice of bundling residential mortgages and selling them as income investments, known as securitization, was commonplace. When some homeowners stopped paying their mortgages during the credit crisis, mortgage products without government backing became hard to sell and suffered declines in value.
The State Fund and Local Government Fund are managed as one, but are separated for accounting purposes. The state treasurer transferred investments from the Local Fund to the State Fund to avoid showing losses in the market value of the investment. The intent may have been to protect local governments from losses, but it appears to be a conflict of interest as the state was allocated the losses.
Anyone who invests money, either for themselves or for someone else, experiences losses from time to time. Ideally the losses are temporary, but in Idaho's case at least some of these bond losses are permanent.
One could argue that all the state's investments should be in a risk-free vehicle suck as Treasury Bills, but as investors we weigh the potential returns versus potential losses, and align investments with the ultimate goal for the money. T-Bills pay zero income and may not meet the investment objective.
We favor the "keep it simple" philosophy. By simplifying the list of allowed investments, the probability of losses is reduced during volatile periods. Risk can be properly evaluated only if one understands the investments in the portfolio. Adding a bank agent and engaging third parties in securities lending complicated the transaction, making mistakes more likely and thereby increasing unforeseen risk.
The treasurer's reference to hindsight bias is valid, but one might question whether this security was suitable in the first place. Like any product-driven strategy, the investment in question was sold to the state, probably involved a commission, likely proprietary, and ultimately transferred unnecessary risk to the owner. Government mortgage securities such as Fannie and Freddie also declined in value during the 2008 crisis, but quickly regained value when TARP and other extraordinary rescue measures were implemented.
As a case study for all fiduciaries, this one is particularly instructive. We commend the treasurer for selecting an investment consultant with knowledge of asset allocation, investment selection, risk measurement, manager selection and ethics. Consultants may also reduce fiduciary risk for the treasurer, as will the involvement of an independent oversight board. The case also illustrates the need for a sound investment policy, and strict adherence to it.
In summary, it appears the funds were comingled in order to preserve the highest credit rating from Moody's and Standard & Poor's. Higher credit ratings reduce borrowing costs for the state. We propose allocating a prorated amount of the losses to the Local Government Fund in fairness to Idaho taxpayers. The treasurer, as CFO of the state of Idaho, has the proverbial "buck" on his desk now, but oversight by an independent board could have prevented an esoteric security like Gryphon Funding LTD P-T NT from ending up as a position in the state's portfolio.
The investment losses are unfortunate, but the apparent effort to conceal them may be the enduring legacy of this financial fiasco.
Mark Daly and Cody Barney are investors and Boise residents.