Two years after the auction-rate bond market froze, Hawai'i has lost about $250 million in market value on $1 billion in student-loan securities sold by a single Citigroup Inc. broker as a cash substitute that the state has had difficulty unloading.

Hawai'i purchased half of the securities for its short-term treasury account from Honolulu broker Pete Thompson in the eight months before the market collapsed, according to Scott Kami, an administrator at the state finance department.

The transactions came while Citigroup was increasing brokerage commissions and traders were being told to "make sure all hands are on deck" and "do whatever is necessary" to dispose of auction-rate bonds as the $330 billion market began to fail, according to a 2008 U.S. Securities and Exchange Commission complaint against the New York-based bank in a separate case related to sales of the debt.

"I was shocked," state Rep. Karl Rhoads said of his reaction when a constituent informed him last year that Hawai'i was stuck with the auction-rate securities. "I didn't believe it. We're a small state, only 1.3 million people."

Hawai'i's frozen-cash crunch complicates efforts by Gov. Linda Lingle to close a $1.2 billion budget deficit as tourism revenue has fallen during the worst recession since the 1930s. She has proposed eliminating 800 state jobs, with teachers being told to stay home without pay for 17 days from November 2009 to May of this year.

Public attention has been focused on Wall Street banks' role in feeding the subprime-debt crisis by creating credit-default swaps, real-estate derivatives and off-balance-sheet financing. The resulting blowup of the U.S. property market led to the 2008 collapse of Lehman Brothers Holdings Inc. and produced $1.7 trillion in financial-company loan losses and writedowns worldwide.

The same Wall Street salesmanship helped fuel a second financial crisis for states, cities and universities from Massachusetts to California that have lost billions of dollars on derivative contracts and municipal-investment deals.

Auction-rate securities typically have maturities as long as 40 years and yields that are reset in periodic sales held as frequently as every seven days. As the global credit crisis deepened in 2008, banks that underwrote the obligations reversed decades of support for the market when they declined to bid for the debt.

CASH SUBSTITUTE

The action left purchasers such as Hawai'i, which viewed auction-rate debt as a higher-yielding cash substitute, unable to sell without taking losses. Citigroup provided the state with a valuation on Dec. 28 saying securities with a face value of about $1 billion were worth $752 million, according to bank documents.

"It was represented to us that these were liquid investments that we could get out every seven to 10 days," Kami said.

Alexander Samuelson, a Citigroup spokesman in New York, said he couldn't comment on Hawai'i's investments or the bank's offers.

"Citi has worked diligently with issuers, investors and regulatory authorities to identify and offer a number of solutions in the auction-rate securities market," he said.

Reached by telephone at his Honolulu office, Thompson said, "I'm not in a position to answer any questions."

He is now employed by Morgan Stanley Smith Barney LLC, a joint venture formed last year by Citigroup and Morgan Stanley.

In a market known for its lack of transparency, Hawai'i's holdings are double the $524 million in auction-rate debt bought by Texas Instruments Inc., the Dallas-based semiconductor maker, which has sued Citigroup, New York-based Morgan Stanley and BNY Capital Markets, now part of Bank of New York Mellon Corp., claiming they misled the company about the securities' liquidity.

Businesses have been unable to gain access to $25 billion of the obligations since February 2008, according to an estimate last year by SecondMarket Inc., a New York-based clearinghouse for illiquid securities.

Under pressure from U.S. and state regulators, 20 firms led by Citigroup; Merrill Lynch, which was bought by Charlotte, North Carolina-based Bank of America Corp.; and UBS AG of Zurich have settled $94 billion in claims, mostly by individual investors who bought auction-rate debt, according to SecondMarket. Corporate and municipal investors have had mixed success pursuing claims against banks in lawsuits and arbitrations, according to Rick Ryder, president of Securities Arbitration Commentator Inc., a Maplewood, N.J.-based newsletter that tracks securities cases.

A federal judge in New York on Jan. 27 dismissed an auction-rate securities lawsuit brought by the mayor and city council of Baltimore against 10 banks led by Citigroup.

"The retail investors were taken care of in the settlements," Ryder said in an interview. "That left the institutional investors with their losses."

'WONDERFUL GUY'

Hawai'i's involvement with auction-rate securities dates back to 1997, when Thompson, a broker since 1984 according to a regulatory filing, lobbied legislators to change the law to permit state investments in bonds backed by student loans.

The auction-rate debt had a "high degree of liquidity" and would allow the state to "earn at least several million dollars more without raising taxes," Thompson told legislators at the time, according to Hawai'i State Archives records.

Thompson was ranked 51st on Registered Rep. magazine's list of the top 100 brokers in the U.S. in 2008, reporting assets under management of $1.6 billion. He is a victim of the collapse of the auction-rate market, his wife, Sylvia Thompson, said by phone.

"He's a wonderful guy; he just got stuck in it," said Sylvia Thompson by telephone from Licious Dishes, her vegetarian takeout shop at Dole Cannery. "Citibank couldn't fund the auctions."

The Thompsons are wine connoisseurs and members of a group of local collectors called the Burgundy Club that meets four times a year to open "extravagant burgundies and Champagnes," according to Stephen Hinck, a manager at the Waikoloa Beach Marriott Resort & Spa on the Big Island, who said his wife is Sylvia's cousin.

The Thompsons are putting their wine collection up for sale, Sylvia Thompson said.

"It's definitely recession adjusting," she said. "Pete's got to reinvent himself, too. He's hurting just like everyone else."

'ATTRACTIVE' PLAN

Hawai'i's auction-rate investments are held in the state's treasury account, which sweeps in money from sources such as highway fuel taxes and harbor tariffs, Budget and Finance Director Georgina Kawamura, whose department supervises the fund, said by phone.

The securities provided higher rates relative to other short-term investments, she said. "While it was working, it was attractive."

Hawai'i owns 67 issues of auction-rate securities, all backed by student loans from issuers such as Reston, Va.-based Sallie Mae and Brazos Student Loan Finance Corp. in Waco, Texas. All but 10 of the issues were underwritten by Citigroup, according to documents provided by the state and data compiled by Bloomberg.

The state purchased the bulk of its holdings in the eight months before the market collapsed. The amount of auction-rate investments climbed to close to $1.1 billion in February 2008 from $452 million on June 30, 2007, according to Kami, who supervises the investments at the state finance department.

Last year, at the urging of the state's accounting firm, Deloitte & Touche LLP, Hawaii took a $114 million writedown on its auction-rate investments, according to Marion Higa, the state auditor.

Higa is preparing a report on the state finance department and its auction-rate investments that would be released shortly. The report is "politically motivated," Lingle said at a Tuesday news conference.

"We intend to hold these securities until maturity as the investments themselves remain sound and the state has been receiving all of the principal and interest payments in a timely basis," Kawamura said in a March 1 letter to Higa released by Lingle's press secretary, Russell Pang.

Hawai'i last year rejected as "sorely lacking" an offer by Citigroup to buy the $1.1 billion in securities at an unspecified discount, according to Randall Nishiyama, Hawai'i's deputy attorney general.

The state's auction-rate freeze is beginning to affect at least one Hawai'i agency's credit rating.

Moody's Investors Service on Jan. 12 downgraded $253 million worth of the state's Harbor Revenue Bonds to A2, the sixth-highest rating, from A1, in part because of a lack of liquidity in the auction-rate securities in the agency's account.

"The diminished value of the auction-rate securities has to some degree reduced the financial flexibility of both the ports and the airports," said Kurt Krummenacker, a Moody's analyst.