It could take up to 35 years for the state to recover nearly $1 billion invested in so-called “auction rate securities”, members of two key legislative committees were told on Tuesday.

During an informational briefing before the Senate Ways and Means Committee and House Finance Committee, legislators questioned whether state officials exceeded their authority and violated state law when they put nearly one-third of the state’s invested cash into the complex investment derivatives during 2007-2008.

The Securities and Exchange Commission describes auction rate securities as “municipal bonds, corporate bonds or preferred stocks with interest rates or dividend yields that are periodically re-set through Dutch auctions.” They have also been backed by collateralized debt obligations, or packages of other debts such as home mortgages or student loans.

The market for ARS collapsed during the sub-prime mortgage crisis, leaving the state government unable to access these funds since February 2008 without selling out at a substantial loss.

A Securities and Exchange Commission investigation resulted in a settlement last year with a number of large Wall Street firms in which the firms agreed to buy back securities originally sold to individual investors and small businesses, but the deal did not apply to large institutional investors like the state. Instead, the SEC only required the brokerage firms to make their “best effort” to liquidate the ARS sold to institutional investors by the end of 2009.

State Budget Director Georgina Kawamura said the state owned ARS with a par value of $975 million as of November 30, 2009.

Kawamura said the state is monitoring the SEC settlement and waiting to see what further enforcement action the federal agency will take, since it appears the problem will not be solved by the SEC deadline tomorrow.

If SEC action does not enable to state to withdraw its funds, Kawamura said the ARS investments will be held until they mature and the original cash is repaid.

In response to questioning, Kawamura said the longest remaining maturity is 35 years, meaning those original funds may not be returned for more than three decades. But Kawamura said the state is currently earning interest and hopes to eventually recoup its entire investment.

“We would take a $200 million actual cash loss if we sold them now, and income from reinvestment would be less than we are getting now (in interest),” Kawamura said. “We are awaiting action by the SEC. But I cannot, in good conscience, sell off these auction rate securities and take an actual cash loss.”

Kawamura said a 1997 state law authorized the state to invest in student loan auction rate securities, “securitized investments backed by individual student loans guaranteed by the federal government.”

At the time they were purchased, all the bonds were rated AAA by rating agencies, Kawamura said. The state could buy and sell ARS through auctions held every 14 to 28 days, and the state treated them as “liquid” investments, Kawamura said, meaning that they could be easily converted to cash. But when the auction market collapsed last year, the money was left out of reach.

Kawamura said the state “recorded a paper loss of $114, but as we continue to hold the securities in our investment portfolio, we haven’t incurred any actual loss.”

“We intend to hold until the liquidity returns or until maturity,” Kawamura told the committees.

Senator Donna Kim, WAM chair, questioned why the amount invested in ARS more than doubled from $452 million in 2007 to more than $1 billion in February 2008.

Kawamura and Scott Kami, administrator of the Financial Administration Division of the Department of Budget & Finance, said the state had taken advantage of the “very attractive investment” that promised at least double the interest rate of alternative investments at the time.

“The yield was subtantially higher for those investments,” Kami said.

Kim then questioned why so much of the state’s money was concentrated in one type of investment, pointing to the state’s policy that generally allows no more than 20% of funds to be put into one type of investment.

In February 2008, ARS accounted for 29% of the state’s investment portfolio, up from just 11% in 2006, and the $975 million now outstanding comprises 37% of the total $2.6 billion portfolio.

Kawamura said the state has a “flexible” investment policy.

“While we do have the guideline of that 20% limit, built-in to the policy is the provision that allows us to exceed it,” she said.

Kim persisted in questioning whether the Lingle administration had complied with state law, which allows short-term investments in “student loan auction rate securities” or “student loan asset-backed notes”, but only if “the investments are due to mature not more than five years from the date of investment.”

“At the time, they were maturing in 7 to 28 days,” Kawamura said, referring to the regular auctions at which the state was able to sell its holdings. But Kim continued to question how the state could be holding bonds that won’t mature for 35 years without violating the law requiring maturities of 5 years or less.

After an hour of questioning, Rep. Gene Ward, a Republican, questioned the direction of the briefing.

“I understood this was an informational hearing, not a ‘gotcha’ hearing,” Ward said.

Several legislators asked whether there were any “red flags” that should have raised concerns about these investments prior to the February 2008 market collapse.

Kami said he had been looking at getting the highest available yield.

“In January 2008, ARS had a substantial rate advantage,” Kami said. “The average yield was 7.39% and the alternative was 2.07% (from other types of investments).”

“Wasn’t the higher yield the red flag, looking at this versus your alternatives,” Sen. Shan Tsutsui asked.

Kami responded: “We didn’t have any indication of any trouble with the market,” Kami said. “I know for certain that all of the investments, when we purchased them, were AAA rated. We, along with a lot of other institutional investors, corporations, and governments, were all caught up in the failure of this auction rate market.”

In May 2006, the SEC found 15 major broker-dealer firms had violated securities laws in their handling of auction rate securities in ways that enabled them to manipulate prices to favor certain customers over others, or favoring the issuer of securities over customers, or vice versa.

According to yesterday’s testimony, state officials have not conducted a formal risk assessment of their ARS investments since they were authorized back in 1997.

Kawamura and legislators also sparred over whether the loss of access to the outstanding $975 million has any measurable impact on state finances.

Kami said the state treasury usually has $3 to $4 billion, but the state never has to spend down to the billion dollar level to pay its operating expenses.

“There’s always money sitting in the account,” Kami said.

Kawamura added that little of the money consists of general funds, with most coming from restricted funds for use by the Department of Transportation’s Highway Division. Much of the money is tied up by bond covenants, financial commitments made when state bonds are issued.

Kawamura said the state purchased these auction rate securities through the local office of Morgan Stanley Smith Barney. According to an estimate by the New York Attorney General’s office, brokers earned about .25% on each transaction, which would translate into about $2.5 million in fees on $1 billion of ARS purchased. However, since ARS were bought and sold as the state managed its short term accounts, the total value of transactions earning fees for the brokerage could be substantially higher.