THE IMPACT OF THE LEHMAN BANKRUPTCY ON THE ABILITY OF UNITED STATES PUBLIC INSTRUMENTALITIES TO PROVIDE NEEDED SERVICES AND FACILITIES

I. INTRODUCTION

After 150 years of continuous operation, Lehman Brothers Holdings, Inc. (“Lehman”) declared bankruptcy on September 15, 2008. The Lehman bankruptcy, the largest in United States history with nearly $700 billion in reported debt, was a triggering event of the ensuing international financial crisis. The Executive and Legislative branches of the United States Government responded rapidly and aggressively after the collapse of Lehman in order to prevent any further failures of other major institutions by adopting the Emergency Economic Stabilization Act of 2008 (the “Act”).

The Act, signed into law by President Bush on October 3, 2008, created the Troubled Assets Relief Program (“TARP”). The Act gives the Secretary of the Treasury the authority and responsibility to provide financial assistance to institutions through the purchase or the Secretary of Treasury determines insurance of “troubled assets”, on such terms and conditions as appropriate. (Sections 101 and 102.) The program is implemented by the newly created Office of Financial Stability. (Section 101.) In exercising the authorities granted in the Act, the Secretary is required to take into consideration a number of factors, including “the need to ensure stability for United States public instrumentalities, such as counties and cities, that may have suffered significant increased costs or losses in the current market turmoil”. (Section 103(7).) Representative Eshoo added this language to the bill with assistance of House Financial Services Committee Chairman Barney Frank.

In fact, on January 14, 2009, Congressman Barney Frank, a primary author of the Act, in response to a question from Congresswoman Anna Eshoo on the Floor of the House of Representatives, confirmed that the Act is intended to provide financial assistance to local governmental entities which were significantly impacted by the Lehman bankruptcy and that the Act expressly provides authority for the Secretary of the Treasury to provide relief to municipalities.

Since adoption of the Act, the Secretary has provided financial assistance in the approximate amount of $380 billion: $148.6 billion to more than 535 financial institutions. This assistance includes approximately $45 billion to the Bank of America, $50 billion to Citigroup, as well as $40 billion to insurance giant AIG and $24.8 billion to automakers. To date, it appears that no assistance has been provided to any United States public instrumentality under the Act.

II. THE MONETARY LOSSES INCURRED BY UNITED STATES PUBLIC INSTRUMENTALITIES AS A RESULT OF THE LEHMAN BANKRUPTCY AND PROSPECTS FOR RECOVERY

As a direct result of the Lehman bankruptcy, many United States public instrumentalities suffered an immediate loss of monies that were invested in Lehman securities. A listing of those public instrumentalities known to have suffered losses as a result of the Lehman bankruptcy, the type of securities held, and the par value of the securities held on the date of bankruptcy is attached as Exhibit A. Upon the filing of bankruptcy, these securities were no longer redeemable from Lehman, even at a loss. As a result, these public instrumentalities were required to write down the value of the securities to zero or, in the case of those instrumentalities, which marked-to-market, to nearly zero.

The prospects of recovery of even a substantial portion of the monies lost as a result of the Lehman bankruptcy are slim. Public agencies have filed claims in the Lehman bankruptcy action currently pending in the District Court for the Southern District of New York. Current estimates are that the bankruptcy will take about two years to conclude. Recovery may be in the range of 20 cents to 30 cents on the dollar for senior unsecured debt.

Additionally, some of the affected public instrumentalities have filed separate lawsuits against senior Lehman executives and Lehman’s auditing firm, Ernst & Young, to recover for losses suffered as a result of the bankruptcy. The timetable for this litigation, and the prospects of any meaningful recovery, are uncertain at this time, but it is clear that any possible recovery is years away.

III. THE IMPACTS OF THE LEHMAN BANKRUPTCY ON THE ABILITY OF PUBLIC INSTUMENTALITIES TO PROVIDE PUBLIC SERVICES

Public instrumentalities at the state and local level are unique in that they are, as a rule, fully funded by the taxpayers. Due to state constitutional and statutory constraints, these entities operate by and large on a “pay as you go” basis, with strict constraints on how much revenue can be generated on a yearly basis. Although public instrumentalities maintain a prudent reserve, these “rainy day” funds leave little room for error. The revenues raised by public instrumentalities are for the direct benefit of constituents served, in the form of services (e.g., teachers, police services, public works services, etc.) or capital improvements (e.g., classrooms, roads, sewer facilities, etc.). A steady and dependable stream of revenue is required to provide services and to ensure that public facilities are properly maintained, modernized and upgraded where necessary.

Revenue collection by public instrumentalities does not occur on a steady ongoing basis. Property taxes, for instance, are collected twice a year in many states. Because income is not collected on a steady basis, and ongoing operations require careful management of cash flow (e.g., to pay salaries), state law also authorizes the treasurers of public instrumentalities to invest idle funds. State laws place strict limitations on the nature of investments that can be made, recognizing that the overriding investment objective is the preservation of capital. In California, for example, investments are restricted to high quality debt instruments, including federal agency instruments, high-grade commercial paper, corporate bonds and similar investments. Returns are relatively low, consistent with the conservative nature of the investment allowed, and are largely intended to keep pace with inflation. Investment portfolios are managed to hold investments to maturity so that return of principal is assured. Many states, including California, allow assets of several public instrumentalities to be pooled to take advantage of the additional flexibility allowed by the larger size of the pool.

The substantial losses in principal incurred as a result of the Lehman bankruptcy has resulted in the direct loss of services and the delay or cancellation of needed capital improvements. These losses include, for example, the loss of many jobs, including teachers, police officers, fire fighters, health care workers and construction workers.

IV. A CASE STUDY—SAN MATEO COUNTY INVESTMENT POOL

Following is a brief “case study” that illustrates how one California county, and numerous school districts, cities, and other public entities in the county, were impacted by the Lehman Brothers Holdings, Inc. bankruptcy. This case study is provided to highlight the public victims of the Lehman bankruptcy and provide background, so that the discussion concerning deferral financial assistance sought by the public entity victims of the Lehman bankruptcy can be put into the appropriate context.

Authority to Invest Public Funds

The San Mateo County Treasurer operates an investment pool, through which the County of San Mateo (“County”) and other public entities in the County can invest funds not necessary for their immediate use. The San Mateo County Investment Pool (“Pool”) operates under authority provided in the California Government Code. 1 Most, if not all, counties in California operate such investment pools. State law strictly limits the types of investments that can be made, and the concentration of pool assets that can be held in a particular type of investment or with any single issuer. 2 The primary objective of the Pool is preservation of principal, and allowed investment options are conservative.

As of September 15, 2008, the date Lehman filed for bankruptcy, the Pool had a total of $2.6 billion in assets, representing the pooled funds of 22 school districts, 15 cities and numerous special districts. As public entities, the Pool participants depend on yearly tax revenues, proceeds from periodic bond sales, and support from the State in order to carry out their responsibilities. The Pool acts as a “holding” fund to manage these revenues until they are needed for ongoing operational purposes and capital improvement purposes.

The Pool’s Investments in Lehman Securities

As of September 15, 2008, the Pool held conservative financial instruments bought through Lehman totaling approximately $155 million in par value. This represented about 5.9 percent of the par value of all pooled assets. These investments included safe “floating rate” securities and one corporate bond. The floating rate securities, by law and County investment policy, were rated A-1 at purchase, and the corporate bond was rated A at purchase. The Pool is prohibited under state law to invest in equities. As a result of the bankruptcy, the Lehman assets were written down to zero (as allowed by law), and are being carried by the Pool as non-performing assets. The San Mateo County Treasurer, the County official who operates the Pool, has filed claims in bankruptcy to protect any remaining value that these assets might have. Additionally, the Pool has filed a lawsuit against senior Lehman executives and Ernst and Young, Lehman’s auditor, to recover these funds.3

The local pool funds represent all manner of public service funding:

Average Investment Returns of Investment Pool

The Pool’s investment history reflects the conservative nature of the Pool’s investment strategy. The Pool’s average gross return on investment for the last 5 years is 3.68 percent. Because of the conservative investment strategies required by state law, and the County Investment Policy, investments make only a return sufficient to keep up with inflation, so that these public funds will not “lose ground” against the general economy. In other words, the Pool is not run for the purpose of turning a profit.

V. THE LEHMAN BANKRUPTCY HAD A DIRECT IMPACT ON PUBLIC INSTRUMENTALITY OPERATIONS AND JOBS

The $1.7 billion dollar loss to local agencies across the nation and specifically the $155 million loss to the San Mateo County Treasury Investment Pool severely impacted the school districts, cities, and other public instrumentalities. The below example illustrates the impact of the loss on one San Mateo County school district. On September 15, 2008, the day Lehman filed for bankruptcy, this school district instantly lost $4,465,000 million in general fund operating money and $20,720,000 in construction bond money, for a total loss of $25,185,000.

The $4.5 million in operating loss eliminated 79 percent of the 2008-2009 District reserve contingency. As a result, the District was forced to immediately eliminate 40 to 60 jobs in the District. The $20.7 million in bond funds lost were slated to match State funds to build new classrooms, computer labs, and an art complex. As a result of the Lehman loss, a total in $35.7 million in projects totaling 156,366 square feet of space has been shelved indefinitely. The financial inability to perform these projects also translates into a significant number of construction job losses. Finally, the voters who authorized the passage of the construction bond and who funded the projects will have nothing to show for their support.

Other losses include:

The County of San Mateo loss of $40 million, which will require the County to abandon plans for a new and urgently needed County jail. The current jail will continue to operate in overcrowded conditions.

The City of Shafter, a small community of 15,000 in San Joaquin County, sustained a loss of $300,000 or nearly 4 percent of its annual budget. The City will be forced to make across-the-board reductions in all services including police and fire.

Monterey County is facing a $30 million loss that will result in cuts to programs that target gang activities and the construction of a new adult and juvenile correction facility to manage these criminals. The City of Folsom lost $700,000, which has caused the City to indefinitely postpone staffing and equipping a new fire station.

City of Costa Mesa lost $5 million that would have funded police and fire services.

The City of Culver City has lost $1 million, which will result in substantial reduction in planned street repairs and high liability exposure from accidents, greater environmental degradation from storm water drain off, and increased traffic congestion in a region of the U.S. already ranked as one of the worst for traffic.

Attached please find a list of local agencies with combined total losses of upwards of $1.7 billion, including, for example: $40 million in Arizona local agencies, $400 million of Florida local agency funds, and $170 million from the State of Oregon Investment Pool.

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1 The Legislature has determined that “by pooling deposits from local agencies and other participants, county treasuries operate in the public interest when they consolidate banking and investment activities, reduce duplication, achieve economies of scale, and carry out coherent and consolidated investment strategies.” Thus, investment pools are favored because of the economies of scale achieved. Ca. Gov’t Code 27130.

2 Pursuant to state law, the primary objectives in managing public funds, in order of priority, are to: 1) safeguard the principal of the funds; 2) satisfy the liquidity needs of depositors; and 3) achieve a return on the funds. Ca. Gov’t Code 27000.5 In furtherance of these objectives, state law places strict limitations on the instruments in which local agencies may invest as well as the concentration of such investments. Ca. Gov’t Code 53601, 53601.7, 53601.8, 53635, 53638, and 53684. By way of general description, treasury pool investments are limited, by statute, to conservative instruments such as U.S. Treasury obligations, highly-rated commercial paper, certificates of deposit, and the like. Treasury investment pools are prohibited, by statute, from investing in equities and are not allowed to purchase other instruments, such as “inverse floaters,” “range notes,” “interest only strips,” and any other securities which could result in zero interest accrual if held to maturity.

3 In another pro-active response to the Lehman bankruptcy, the San Mateo County Board of Supervisors retained outside consultant PFM Asset Management LLC to perform a risk analysis of the Investment Pool. PFM concluded that the Pool is invested conservatively and presents no further immediate risk to the County.