Hawai'i has continued to use Citigroup Inc. to help underwrite $2.7 billion in debt even after one of the bank's brokers sold the state $1 billion in auction-rate securities that have lost a quarter of their market value and cannot be redeemed easily.

Citigroup, the third-largest U.S. bank by assets, was among the underwriters earning almost $13 million in fees from issuing Hawai'i municipal bonds since the auction-rate securities market froze in February 2008, according to data compiled by Bloomberg.

Citigroup, based in New York, served as senior manager for Hawai'i on a $645 million sale of revenue bonds for the state's airports system on March 24.

It's surprising that Hawai'i hasn't barred Citigroup from underwriting bonds as a way of pressuring the firm into settling over auction-rate investments, said Thomas R. Ajamie, a Houston- based attorney who represents some individual holders of the securities but does not have any business with Citigroup or the state.

"We always tell our clients, 'If you want to show you are upset, let your money do the talking,' " Ajamie said in a telephone interview.

"The use of Citi to be our underwriters has nothing to do with investing in auction-rate securities," Russell Pang, a spokesman for Lingle, said in an e-mail.

BANK'S RESPONSE

"The State has an exhaustive contract process before any underwriter is engaged for a specific financing which includes a detailed fee proposal which must be approved by the state," Alexander Samuelson, a spokesman for Citigroup, said in an e- mail.

Citigroup's auction-rate securities sales to Hawai'i were proper, and the firm continues to provide bond-underwriting services because of its qualifications to do the work, Samuelson said.

"We believe Citi and its representatives acted appropriately," he said. "As state representatives have publicly stated, Hawai'i's auction-rate-securities purchases were both appropriate and in compliance with applicable laws and policies. Although the state has indicated no current liquidity needs exist, Citi can provide options if those needs change."

Auction-rate securities, backed by pools of federally guaranteed student loans, were sold to the state as low-risk substitutes for U.S. Treasury bills by Citigroup broker Pete Thompson, 60, in Honolulu. They get their name from the weekly, bank-run auctions where the interest rate they pay investors is determined.

The $330 billion auction-rate securities market froze when banks stopped supporting the auctions in the worst credit crunch since the Great Depression. Hawai'i's state treasury wrote off $255 million of its purchase price on the securities to reflect their diminished value, even as Gov. Linda Lingle battled a $1.2 billion budget deficit that forced the state to furlough teachers on many Fridays.

Hawai'i last year rejected as "sorely lacking" an offer by Citigroup to buy back at an unspecified discount the auction-rate securities sold by Thompson, Randall Nishiyama, a deputy attorney general, said in a telephone interview earlier this year. The bank also offered to lend the state as much as $572 million, at 3.85 percentage points above the federal funds rate, according to a term sheet for the proposed deal.

LEGISLATIVE PROBE

Citigroup's auction-rate sales prompted Hawai'i's Legislature to vote April 22 to create a committee to investigate whether the Department of Budget and Finance acted legally by investing one-quarter of the state treasury's spare cash in the securities.

The move followed agreements with 20 firms, including Citigroup, Bank of America's Merrill Lynch unit and UBS AG, to pay $94 billion to settle claims by the Securities and Exchange Commission and state regulators that they misled purchasers about the risks of the investments, according to SecondMarket Inc., which runs an exchange in New York where the bonds can be traded.

Most of that money went to small investors who were reimbursed by the banks. The lenders were required only to make their best efforts to reach accommodations with larger investors, according to SecondMarket.

"Every other group seems to have been made whole," Donna Mercado Kim, the Hawai'i Senate Ways and Means Committee chairwoman, said in a March 24 interview.

"I would have been first in line."

Hawai'i's auction-rate purchases began after Thompson, a former community activist who became a broker in 1984, successfully lobbied legislators in 1997 for a change in state law to permit the transactions. The state could "earn at least several million dollars more without raising taxes" or "slashing any existing programs," Thompson said, according to a transcript of his testimony.

Thompson was ranked 51st on the trade publication Registered Rep's list of the top 100 brokers in the U.S. in 2008, with assets under management of $1.6 billion. As a student at the University of Hawai'i in the early 1970s, Thompson was a Vietnam War protester and ethnic-studies instructor, said John Witeck, a fellow activist who now works in human resources at the school in Honolulu.

'VERY METICULOUS'

"Pete was one of the spark plugs, very bright, a charismatic speaker," Witeck said in a March 12 telephone interview. "He was always good with numbers. He's very meticulous, always very organized."

Hawai'i's Department of Budget and Finance, which manages the state treasury, made its first investments in student loan auction-rate securities in 1998, according to a March 18 report by state auditor Marion Higa. The agency's holdings climbed from $427 million in July of 2007 to nearly $1.1 billion in February 2008, when the auctions that allowed investors to sell the bonds began failing.

Hawai'i purchased the bulk of its auction-rate holdings in the last eight months before the market collapsed in February 2008, according to the state auditor's report. The transactions continued even as Citigroup said in internal e-mails as early as August 2007 that the market was failing, according to a 2008 SEC complaint.

While Hawai'i bought all its auction-rate bonds from one broker, other states limit the amount officials can purchase from a single firm. Maryland works with more than 18 brokers and cannot do more than 10 percent of its business with any one, Mary Christine Jackman, director of investments at Maryland's Office of the State Treasurer, said in a telephone interview.

"We never have, nor will we ever, buy auction-rate securities," Jackman said. "Most public funds don't have the depth of bench to do the constant analysis and monitoring that these securities need."

Thompson didn't know the market was failing when he sold the state the bonds, he said in a March 24 interview as he handed out samples of his wife's vegetarian food at a farmers market near downtown Honolulu.

The broker is now employed by Morgan Stanley Smith Barney, a joint venture formed last year through the merger of Morgan Stanley's and Citigroup's brokerage businesses.

"I'm sure you've gone through all the legal filings and seen the e-mails that were flying around from higher-ups," Thompson said.

"The guys like me — we didn't know any of it."