Treasurer Lemoine Speaks to Appropriations and Financial Affairs committee regarding Mainsail II investment
December 12, 2007
Mainsail II Investment Remarks David G. Lemoine, Treasurer December 12, 2007
Thank you Senator Rotundo and Representative Fischer for building time for this presentation into today’s already busy agenda. I very much appreciate the opportunity to discuss state cash pool investments in a full, open and unedited way. Investment policies and results need to be considered with a cool and clear head, and I know Maine’s media environment recently has not entirely favored that approach.
Before I go further, let me first applaud the diligence with which all the members of this committee have been attending to the Mainsail II investment default. In particular, I want to thank Rep. Giles for so promptly identifying the key issues surrounding the Mainsail II investment and for allowing me to use her insightful questions as a vehicle for informing other legislators about the situation.
My message this morning is this:
Maine’s cash pool assets are invested wisely, cautiously and with as little risk as is consistent with sound money management and cash flow needs. And directly to the point - Maine, unlike some other states and even the largest investment banks, has had only minimal exposure to the market troubles brought on by the worldwide subprime crunch.
For decades now, Maine’s conservative cash pool investments have included commercial paper. In recent years, Treasury’s approach to commercial paper investments has relied upon the guidance of a professional cash pool investment advisor (MBIA), with commercial paper investment options offered through a limited group of pre-qualified financial advisors. Since commercial paper is really just lending money to corporations, we have also required top credits rating from two of the three major credit rating agencies, (Moody’s, Standard & Poors or Fitch.)
This 3-tiered investment screening process saw Maine safely through the dot.com bust, the post 9-11 economic contraction, and many other investing challenges over the years. I had understood the process to be tried and true, but it failed on August 20th last summer in what some objective investment professionals have since called a “black swan” event. That is, an event which is unbelievable until actually seen.
In the Mainsail II case, Treasury lent $19,930,361.11 on August 8th at an interest rate of 5.45% to a company suggested by a long-standing financial advisor, with top-notch credit ratings of A-1+ by Moody’s and P-1 by S&P, under a legal obligation, back by real assets, that 23 days later we would be repaid with interest, for a total of $20 million. Only twelve (12) days after we lent the funds, Mainsail’s business activities were frozen and the next day the credit was downgraded to junk-status. Recovery of the funds is now controlled by the specific resolution efforts of other, much larger, Mainsail creditors, which is in turn caught up in the general turmoil which is afflicting the world’s credit markets,
In light of the Mainsail developments in August, Treasury immediately stopped investing in commercial paper. We have since then virtually eliminated commercial paper from our portfolio. The bulk of cash pool funds are now in fully collateralized accounts at several large banks. As I will note in a timeline discussion in moment, Treasury had been curtailing commercial paper investments in early August. We left the market entirely after the Mainsail experience.
In order to move forward from here with prudence, not panic, I have formed a Cash Pool Investment Design Committee. My goal is to have this group consider the long-term implications of the subprime situation, and to generate an investment design which would be supported by a new Investment Advisor contract next May. Maine’s current investment advisor contract expires at that time.
Let’s look at the details of the Mainsail II transaction through four (4) broad questions:
What is the State's cash pool investment policy and process?
How did that policy and process play out in the Mainsail II investment?
How did Treasury respond to the Mainsail II developments?
Where do we go from here?
What is the State's cash pool investment policy and process?
Cash pool assets are the revenues received by the State but not immediately needed to pay bills. Every working day, the Treasurer’s Office comes in, checks the bank balances for revenues received overnight and compares them to the expenditures schedules available from the Controller's Office. If there are unneeded funds, we put them to work for the State through conservative investments. The average daily balance of the State investment pool totaled more than $675,000,000 in fiscal year 2007.
From the first of July through the end of November this year, these earnings have totaled $14,890,570. Last biennium the earnings reached $64 million. Over the last 10 years Treasury has earned $280.2 million for the State of Maine by using a prudent and proven investment structure that included the use of commercial paper.
Investment decisions for the cash pool are made under both statutory and policy guidelines, with emphasis on security and liquidity. Commercial paper, which is the process by which Maine lends money to corporations, is set out in statute as a permitted investment category. There are two general types of commercial paper, "asset-backed" and "named."
Traditionally, lending funds to someone who has not only the legal obligation to pay it back, but also assets pledged to secure repayment, has been considered an extremely safe investment. With various borrowers in the market every day, we were able to invest for the targeted maturity dates that were most useful cash flow purposes.
Most importantly, Treasury has always required A-1/P-1/F-1 credit ratings (2 of 3) for each borrower before we authorized a transaction. Moody's rates commercial credit from A-1 down, Standard & Poors from P-1 down and Fitch Ratings from F-1 down. The Mainsail II credit was rated as A-1+ and P-1 when purchased. It exceeded Maine’s already stringent requirements.
The credit rating is only one of three screens used at Treasury to identify quality commercial paper investments.
Before we lend out commercial paper funds, our investment advisor, MBIA, has pre-qualified a limited number of financial advisors who are authorized to offer Treasury staff commercial paper investments. We then rely on the professional judgment of those financial advisors in bringing forward quality investments. The third and final safety check is the demand for a top credit rating to assure the credit-worthiness of the debtor.
In addition to these targeted commercial paper investment screens, Treasury also receives monthly reports and we have quarterly face-to-face meetings with our MBIA investment advisor. Those reviews look at our investment structure, the cash pool’s overall performance, and most relevant here - our investment practices.
Finally, it is important to note that we do not invest in stocks or other equities that fluctuate with the trading markets. Our exposure to the subprime crunch came through straightforward, safe and short-term commercial paper debts that were legally obliged to be repaid at a set time with a set amount.
Of the thousand of such transactions made by the Treasury over the years, I am aware of only one that has failed.
How did the investment policy and process play out in the Mainsail II investment?
7/31 - $3,999,398.89 was invested for one day in Mainsail II Commercial Paper (the “Mainsail Commercial Paper”) issued by Mainsail Limited, an affiliate of Solent Capital Partners, LLP (“Mainsail”). Mary Ruch, a financial advisor with Merrill Lynch who was approved by the state’s investment advisor MBIA and who has been doing brokerage business with the state without any problems for many years, sold the paper to the state. The paper was rated A1+ and P1 by Standard & Poor’s and Moody’s, respectively, and bore interest at 5.41% with a maturity of August 1, 2007.
While it was indicated by the broker that the instrument was asset-backed commercial paper meeting the state’s rating requirements, it was not indicated that Mainsail was a structured investment vehicles (SIV) which arbitrages between short-term and long-term debt. SIVs issue short-term commercial to raise funds, which is continually rolled over to pay itself off.
8/1 - Two hedge funds managed by Bear Stearns that invested heavily in subprime mortgages declared bankruptcy. Investors in the funds file suit against Bear Stearns, alleging that the investment bank mislead them about the extent of the funds’ exposure.
Mainsail Commercial Paper bought on 7/31 matures and payment is made in full.
8/6 - Weekly Treasury Management meeting discusses subprime market challenges and potential impacts on the Cash Pool. Staff discussions planned with MBIA, the cash pool investment advisor, on the market situation. Investment in prime A1, P1 commercial paper still permitted per policy.
8/7 - The Federal Open Market Committee leaves the overnight federal funds rate at 5.25%, referring to tightening in the credit markets and ongoing housing market crisis as a “correction”. Despite financial market turmoil, the FOMC forecasts that “the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in the employment and incomes and a robust global economy.”
8/8 - On August 8, 2007, $19,930,361.11 was invested in Mainsail II Commercial Paper (the “Mainsail Commercial Paper”) issued by Mainsail Limited, an affiliate of Solent Capital Partners, LLP (“Mainsail”). Mary Ruch of Merrill Lynch again sold the Commercial Paper to the state. This Mainsail Commercial Paper was rated A1+ and P1 by Standard & Poor’s and Moody’s, respectively, and bore interest at 5.45% with a maturity of August 31, 2007. This investment was made in accordance with State law and State investment pool practice. By practice we limit the maximum investment allowed in any single issuer of commercial paper to $20,000,000 and ratings of A1 and P1 or better are always required.
And again, while it was indicated by the broker that the instrument was asset-backed commercial paper meeting the state’s rating requirements, it was not indicated that Mainsail was a structured investment vehicles (SIV) which arbitrages between short-term and long-term debt.
8/9 - American International Group, one of the biggest U.S. mortgage lenders, warns that mortgage defaults are spreading beyond the subprime sector, with delinquencies becoming more common among borrowers in the category just above subprime.
8/9, 8/10 - European Central Bank and Federal Reserve intervene by pumping billions of dollars of liquidity into the markets.
8/10 - Extreme market volatility erupts in the liquidity sector. Treasury investment personnel meet to discuss limiting purchases of what has suddenly become high risk CP (mostly asset backed CP) and moving towards corporate and financial companies for longer term (7 days or more) CP.
8/14 - Standard & Poor's, the ratings agency, warns that it might downgrade several issuers of commercial paper.
8/16 - Countrywide Financial, the nation’s largest mortgage lender, draws down $11.5 billion from its credit lines.
8/17 - The Federal Reserve cuts the discount rate by half a point. Stocks rally.
8/20 - If the value of a SIVs investment portfolio declines too much, a SIV will trigger a major capital loss test. In doing so, a SIV enters a mandatory wind-down: no opportunity to restructure, no opportunity to carefully unload assets. Bank of New York, Mainsail’s security trustee, market tests Mainsail’s underlying assets and finds that it fails the capital adequacy test. This prevents Mainsail from issuing new CP and freezes Mainsail’s assets making selling the CP in the secondary market nearly impossible. Mainsail announces in a press release that it might be forced to sell assets because it had been unable to raise short-term funding due to market volatility.
Treasury discontinues purchases in Asset-backed Commercial Paper, due to market & ratings volatility.
8/21: Standard and Poor’s downgrades Mainsail CP from A1+ (highest possible rating) to B (junk status).
8/22: Treasury stops investing in any commercial paper, “names” as well as “asset-backs.”
8/31: On August 31, 2007, the approximate $20,000,000 Mainsail II payment was not received when due. Mainsail publicly reports that it will be forced to sell assets because it had been unable to raise short-term funding due to market volatility.
9/5: Treasury determines that CD rates have become attractive and prudent, and begins moving assets to these vehicles.
9/6 - The security trustee for the Mainsail Commercial Paper, Bank of New York, stated that it had received details of a restructuring proposal for Mainsail from Barclays Capital. The restructuring proposes that all commercial paper investors under Mainsail's $4,000,000,000 program will be paid back in full at par via a liquidity facility to be determined and underwritten by Barclays Capital. The plan is now awaiting approval by the security trustee, Bank of New York, in what appears to be an extensive process. See attached press clipping.
9/18 – Fed reduces prime rate by 50 basis points to 4.75%
11/02 - Treasury staff listen to a conference call for Mainsail II investors. It is announced that the Barclays Capital proposal to pay in full all commercial paper holders would not happen.
11/26/07 – News reports say that Barclay’s provided Mainsail “with temporary funding, but Mainsail investors rejected a Barcap rescue package in favor of a sale,” and that The Bank of New York “has appointed the firm Houlihan Lokey Howard & Zukin to find buyers for its assets.”
Where do we go from here?
This is an appropriate time to take apart our cash pool investment process and policies and to examine each assumption and practice. That’s the purpose of the Cash Pool Investment Design committee that I announced just a few moments ago. We all need the clear-eyed and cool-headed analysis that the committee design review will generate. And Treasury will use that design as we go through the Request for Proposal (RFP) for the next Investment Advisor contract.
Finally, let me address the issue of investment credential for the State Treasurer and respond to what I see as misplaced calls for sanctions over the Mainsail investment decision.
As you all know, experts don’t always agree on what is the right advice. Treasury had some of the most qualified professional advisors in the nation working with us when the Mainsail II investment was made last August. Even here in Maine, very few experienced financial advisors have a perfect record.
And being State Treasurer is more than being a short-term investment professional. It’s about making choices that affect a broad range of public policies.
For instance, look at some of the other work being done at Treasury.
Transitioning the 20-year-old state accounting system into the new Advantage system depended upon integrating two key Treasury functions; Cash Receipts and Reconciliations between bank records and the accounting system. I made the policy decision to place thousands of hours of Treasury’s resources into assisting that effort. While I’m neither a computer programmer nor an accountant, I concluded that making the Advantage system work was best for the State. Programmers and accountants, and great oversight from Controller Karass, made it happen.
I was told three years ago that we needed 10-15 new employees in our Unclaimed Property operation or our functions would collapse. I’m not an unclaimed property expert and I’m not an internet programmer, but I knew that we had to find another answer. I asked staff to break down each step in the process, sought expert outside advice, rebuilt our procedures and made substantial changes in online systems. We ordered a modern version of the backbone software system and staggered our unclaimed property advertisement delivery dates in the spring. We ended up cutting two positions and we still get claims paid months faster than before.
I wanted Treasury staffing to be managed under one management system, with all positions clearly showing up as in the budget as general fund positions. We succeeded. I’m not a management expert or an expert at budget analysis, but transparency for the budget-makers was a policy goal.
I’m not a bond trader, but I wanted Maine investors to have the choice to buy Maine bonds if they wished. For the last two years I have been contacting Maine financial advisors to give notice of Maine’s general obligation bond sales before we go to market. Last June nearly 100% of Maine bonds were purchased by Maine residents.
I’m not a professional underwriter, but I believe that the judicious use of state bonds can improve Maine’s economy and quality of life. As a result, I worked closely with the Administration, this Committee and legislative leadership to encourage use of pre-determined draw schedules for bond proceeds. Adding this certainty to the debt-service budget projections helped structure the resulting 2007-2008 bond package.
I’m not trained as a controller or a credit analyst. But I recognized that Tax Anticipation Note (TAN) borrowing was a negative pressure on Maine’s credit ratings, and worked with the Controller to more fully utilize our Cash Pool resources to meet Cash Flow needs. Last year, Treasury covered over $300 million in General Fund cash flow needs without any external borrowing. A success noted with approval by the rating agencies.
I’m not in event promotions, but I knew a good opportunity for Maine when I saw it. The National Association of State Treasurer’s will be coming to Maine next August for its annual meeting. I sought that conference because bringing it here is good for Maine and consistent with my policy of promoting Maine wherever possible.
I’m not a financial literacy expert, but I have taken up the fight for financial literacy in Maine. This fall Treasury brought in national experts and recorded a professional development financial literacy seminar for teachers. It’s considered a national model for reaching more teachers because it’s available for viewing at home at low expense. We have begun implementing a matching grant program for financial literacy efforts, and have joined other New England Treasurers for a high school financial literacy competition.
The State Treasurer also serves on, and I believe contributes to, the work of many boards, including the Retirement system, Housing Authority, FAME, MELA, MMBB, Dirigo Health, and several others.
There is more to being State Treasurer than making daily investments from the cash pool, as compelling and critical as that function is.
In all these areas of involvement, it has been my goal to create an efficient, open and professional office that promotes the public good and is responsive to the needs of elected policy makers. I expect future cash pool policy discussions to hold to those standards, and would be pleased to answer any questions you may have.