NEW YORK - State treasurers from Florida to Maine to Montana found themselves in the awkward position last week of having to explain why they had parked taxpayer money in some of the most opaque investments on Wall Street.
More than a dozen state-run cash pools that manage money for local governments have some exposure to mortgage-related and other high-risk holdings that roiled credit markets during the summer, according to the ratings agency Standard & Poor's.
The fear now is that the same subprime-mortgage turmoil that triggered huge write-downs for Wall Street's biggest banks may trickle down to teachers and civil servants because of the way public funds were invested.
Troubles first emerged as Florida officials disclosed that their $27 billion investment pool had about $2 billion sunk in subprime-tainted debt - and that $725 million of the debt already had defaulted. Local governments rushed to withdraw about $13 billion from the battered fund, and there are worries that similar runs may take place elsewhere.
State finance officials who invested in mortgage-related instruments say they were lured by sterling credit ratings and a promise of a higher return than could be earned on three-month U.S. Treasury bills, which now yield about 3 percent.
"We relied on professional advice from our brokers and rating agencies," said David Lemoine, Maine's state treasurer. "And then there's an unprecedented collapse of a super-highly-rated investment almost overnight."
Lemoine called it "inconceivable until it happened." He invested about $20 million, or 3 percent of Maine's $725 million cash pool, in commercial paper issued by what are known as structured investment vehicles, or SIVs. Though no money has been lost so far, Lemoine said it could take months to unravel what was intended to be a short-term investment.
Maine and other government entities - including Connecticut, Florida, Montana and King County in Washington - were drawn to the highly rated commercial paper issued by an SIV called Mainsail II, which was operated by the British hedge fund Solent Capital Partners L.L.P. Mainsail's commercial-paper offerings later were downgraded to junk by rating agencies because of concerns about whether the SIVs could repay the money they owed.
SIVs are typically offshore investment vehicles created by banks and other firms to sell commercial paper, a form of low-yielding, short-term debt that comes due every 30 to 90 days and generally is rolled over into new issues by those holding it. The cash generated from those sales was used to buy higher-yielding mortgage securities.
These paired transactions were profitable as long as the SIVs collected more on the mortgage investments than they paid to borrow. But that breaks down if SIVs are unable to continue borrowing money, which could force them to sell the underlying mortgage-related securities at fire-sale prices. In worst-case scenarios, that could leave commercial-paper buyers holding the bag, since the SIVs could only pay them back a portion of the money they were owed.
Likewise, state funds facing a run on their deposits also could be forced to liquidate some of their holdings at a loss. To salvage its fund, Florida walled off $2 billion of the weakest investments and imposed restrictions to limit withdrawals that would drain coffers.
What makes the situation more daunting is that nobody on Wall Street is exactly sure how many investment pools have money tied into SIVs or other subprime exposure. Ratings agencies monitor the investments of fewer than 100 government-run cash pools; hundreds of others go unrated.