Montana and Connecticut join Florida in local government investment mess. Will California's LAIF soon follow?

From Bloomberg:

Dec. 3 (Bloomberg) -- Montana and Connecticut state-run investment funds hold debt tainted by the subprime mortgage collapse that was cut or put under review by Moody's Investors Service, leaving local governments vulnerable to losses.

Moody's lowered its rating on commercial paper issued by the Orion Finance structured investment vehicle, or SIV, to ``Not Prime'' on Nov. 30, saying its net asset value is inconsistent with Orion's former Prime-1 rating. Montana owns $50 million of the paper. Moody's put another $105 billion of SIVs on review for a possible downgrade, of which Montana holds $80 million and Connecticut holds $300 million, records show.

``This just reinforces the fact that we have a serious issue,'' said State Senator Dave Lewis, of Helena, Montana, a member of the Legislative Audit Committee.

Schools, fire departments and towns across the U.S. that use state- and county-run funds like a bank account are seeing the far-ranging effects of the housing slump, as complex investments once sold as high-yielding, safe havens are now backed by collateral investors don't want.

Modeled after private money-market funds, the investment pools are supposed to hold safe, liquid, short-term debt.

In Florida, disclosures that a state-run pool for schools and cities held $1.5 billion of downgraded and defaulted debt prompted governments to pull out almost half of the fund's $27 billion in assets. Officials halted further withdrawals on Nov. 29 as they consider options to address the crisis.

Montana's $2.2 billion fund has already had $250 million of withdrawals since the fund's $90 million holding of Axon Financial was cut to ``D,'' or default, by Standard & Poor's last week. It was lowered to ``Not Prime'' by Moody's on Oct. 23.

Montana SIVs

The Montana pool, managed by the Montana Board of Investments, has 25 percent, or $550 million, invested in SIVs, all of which carried top investment ratings when purchased.
SIVs are typically offshore companies created by banks and other firms to sell short-term debt to buy mortgage securities and finance company bonds with higher yields. They profit on the spread between the two. Moody's last week said it may lower ratings on $105 billion of debt sold by SIVs after the average net asset values of those sponsored by firms including New York- based Citigroup Inc. declined to 55 percent from 71 percent a month ago. The assets were valued at 102 percent in June.

Connecticut Investments

Connecticut's Short-Term Investment Fund, which invests cash for state agencies and municipalities, is holding $300 million in debt issued by SIVs that may be downgraded by Moody's. The state's $5.8 billion fund held notes issued by SIVs affiliated with Citigroup as of Sept. 30: Beta Finance, Dorada Finance and Five Finance, according to its most recent quarterly report.

Connecticut also holds $100 million in defaulted SIV notes issued by Cheyne Finance.
Lewis, a member of the Legislative Audit Committee in Montana, questioned whether the state board's policy of allowing pool participants to remove their money at full value, which concentrates the risk among those with money still entrusted to the pool. The majority of the money in the pool belongs to state agencies.

``I think we may need a special session of the state Legislature,'' he said