Big Chill Hits Florida's SBA

The cold winter weather is pounding Florida's citrus belt, putting the state's US$9.3 billion-per-year citrus industry in jeopardy of a widespread freeze.

But as you will read below, $9.3 billion is a pittance compared to the losses Florida's State Board of Administration (SBA) racked up last year.

Back in August, I commended Florida's SBA, citing an article which ranked it high among public pension funds. In particular, I stated that Canadian public pension funds can learn from Florida's SBA, focusing on the clear benchmarks they presented in all asset classes, including alternative investments like real estate and private equity.

I still think Canadian public pension funds should clearly present the benchmarks governing internal and external investment activities, but I was dead wrong about Florida's SBA being transparent and accountable and I did not take a closer look at their exposures to alternative asset classes and equities or the lax oversight that governed these investments.

In December I wrote about LDI strategies containing pension deficits and specifically stated that is was mind-boggling to see pension consultants recommending no major investment strategy changes for Florida’s public employee pension plan although it has lost billions in the financial market meltdown.

I shared those thoughts with Sydney Freedberg, an investigative reporter at the St-Petersburg Times, who just published an excellent article in that newspaper, How to scramble a state's nest egg:

The State Board of Administration is supposed to play it safe. It protects $97.3-billion in pension money for nearly 1-million current and retired teachers, public employees and their families.

It invests an additional $25.3-billion for more than 800 school districts and state and local government entities to, among other things, pay police and teachers, buy books and health care for children and help hurricane victims.

But in audit after audit over the past eight years, the supposedly low-risk agency was warned again and again about making risky, complex investments, without proper controls.

Now, with the economy tanking, the overexposure to risk highlighted in those audits has come back to haunt the SBA. In the past 18 months, one-third of the agency's assets — $61.4-billion — have been wiped out.

For just a single trading strategy that aroused scrutiny in three audits between 2001 and 2007, the agency recently announced a possible loss of up to $506-million.

The SBA says the dramatic drop reflects the market downturn, nothing else.

"Everybody has suffered,'' executive director Ash Williams said recently. "We're still one of the strongest funds in the country.'' [sigh!]

But the audits tell a different story: Senior managers repeatedly were told to take steps to reduce risk, but for the most part, they stayed their risky course.

In March 2007, for example, the SBA's top auditor identified a conflict of interest that four previous audits had reported:

"The reappearance of the same issue in several audit reports issued by different sets of auditors, and the lack of action to address or mitigate this issue exposes the SBA and its management to additional risks.''

• • •

The SBA is governed by a three-member board of trustees: the governor, the attorney general and the chief financial officer.

In the 1980s, with the blessing of that board and the Florida Legislature, the SBA turned riskier. It livened up humdrum bond portfolios with more stocks and took volatile bets on real estate and private partnerships.

Between 1994 and 2000, SBA assets rose from $51-billion to $128.2-billion. As other states struggled with funding deficits, Florida bragged of surpluses to meet its pension promises for decades to come.

The stock market collapse of 2000-01 brought pressure to juice up returns, compounded by the agency's loss of $281-million on Enron stock.

With continued support from the trustees, the SBA's money managers opted for high stakes and increasingly complex financial strategies. Auditors, meantime, warned of lax oversight and controls that could lead to undue risks, avoidable losses and even fraud.

Early warnings surfaced in the small unit that manages real estate investments — everything from farms to shopping centers.

In 2000, 2002, 2004 and again in 2007, auditors and a watchdog group questioned whether staffers properly vetted and monitored properties. In one report, auditors cited the risk of "leverage''— the use of borrowed money that can jack up profits in a boom but deflate them in a recession.

"It is unclear to an individual looking from the outside where the (real estate) portfolio is headed,'' SBA chief internal auditor Flerida Rivera-Alsing said in 2004.

In response, the SBA said it would hire an independent appraiser. But the agency backtracked. It didn't hire an appraiser, and it invested in funds that bought debt-laden properties. Now that the real estate market has collapsed, borrowed funds are magnifying losses.

The SBA's deputy executive director, Kevin SigRist, says the agency addressed many of the audit recommendations. "It's a reality that you can't effect every change instantaneously,'' he said, adding that the SBA is always looking to improve its procedures.

Back in 2007, just before the credit crunch blew property markets to pieces, the agency invested in a $5.4-billion apartment complex on 80 acres in Manhattan. Known as Stuyvesant Town and Peter Cooper Village, it was the priciest real estate buy in American history.

Some real estate experts questioned the sky-high price tag and huge amount of debt used to finance the deal. They said investors could be waiting at least seven to 10 years to see meaningful profits, which might be too long for a pension fund to tie up its money.

The SBA invested $250-million anyway.

Now the property's value has dropped 10 percent and Wall Street credit firms have downgraded bonds tied to the deal. Low on cash, the private sponsors have asked investors to put up more money. The SBA's share: $30-million more.

SigRist blames problems not on inadequate vetting, but on the changing financial world.

Last month, at a meeting of a group that advises the SBA on investments and policies, a Jacksonville investor who serves as an unpaid SBA adviser took the agency's real estate unit to task over the New York apartment deal. "A lot of the (investors) feel like the assumptions were pie in the sky,'' James Dahl said.

He asked top managers how much they would get if they sold their stake in the apartments.

"You wouldn't be able to sell anything in this market today," replied Doug Bennett, senior investment officer of the real estate unit. "... We just hope that it will basically survive this economic situation that we have.''

Dahl's conclusion: "I think our $250-million is worth zero.''

• • •

In 2001, 2002, 2004 and 2006, auditors raised red flags about volatile "alternative investments,'' strategies such as buyout transactions and venture capital funds. These private investments are sometimes called "black box'' deals because investors' money flows to secretive partnerships that are not publicly traded or regulated.

Once the SBA makes the investment, there is almost no oversight or public disclosure as to where the funds go next, how they are managed, or when, if ever, investors will reap returns.

Three times legislative auditors warned that the SBA's alternative investments were under-performing. They noted the high management fees compared to other types of investments.

"The SBA needs to consider whether the expected returns from these investments are sufficient to compensate for their risks and high management costs,'' the auditors said in 2002.

In 2004, the auditors repeated the identical recommendation, though they did change three words in the sentence: "The SBA should consider whether the returns from these investments are sufficient to compensate for their risks and high management costs.''

Last year, the agency committed more than $4-billion to 33 private deals, including funds affiliated with legendary traders such as the Carlyle Group, Blackstone Group, Apollo Management and Kohlberg Kravis Roberts & Co.

Using cheap credit and Florida's money, some of these firms bought big-name companies at astronomical prices. The megadeals bought the SBA a piece of marquee companies, including Hilton Hotels and Harrah's Entertainment.

Now, alternative investments are getting creamed.

Saddled with debt, Harrah's saw its credit rating cut last month to "selective default.'' Blackstone, which engineered the Hilton buyout, reported a $502.5-million loss for its third quarter. KKR's shares plunged 89 percent last year. Carlyle has cut 10 percent of its 1,000-person staff.

Some large pension funds and endowments are unloading private investments at deep discounts — often 50 to 60 cents for every $1 invested.

But Florida is sticking by its private commitments. In May, Gov. Charlie Crist went to the floor of the New York Stock Exchange to sign a bill allowing the SBA to double its exposure to alternative investments, saying it would mean more high-wage jobs for Floridians.

"Today I have traveled to Wall Street to bring the message of Florida's innovation economy to the epicenter of the world's financial community,'' Crist said.

About five months later the stock market crashed.

"Inevitably, in this market environment,'' SigRist says now, "there will be some individual investments that will be challenging.''

• • •

The SBA's troubles weren't isolated to its riskier units. The fixed-income unit was supposed to handle plain-vanilla, low-risk trades on behalf of pensioners and public agencies that had their extra cash parked in accounts to pay teachers, bills and benefits.

But this unit was also betting billions on exotic investments with lofty names, including Pinnacle Point, Catapult and Luminent Star.

Some of the bets made by the SBA's supposedly safest unit came up big-time losers.

Two reports by SBA consultants — in March 2004 and October 2005 — foreshadowed the problems.

Staffers in the unit were not keeping adequate records of how they picked brokers. They also were using complicated financial instruments called derivatives, which billionaire investor Warren Buffett once called "financial weapons of mass destruction.''

The consultants recommended better reporting and monitoring, but problems remained. In December 2005, an audit by Rivera-Alsing again took aim at the fixed-income unit.

The report was scathing. It portrayed a system of conflicts in which staffers chose the bets, picked the brokers and processed and monitored their own transactions.

Rivera-Alsing also identified $34-billion of "dummy trades,'' transactions in which no broker or a fictional broker identification number was used to record a trade.

"The potential for errors or irregularities is high when the recording of dummy trades is allowed,'' the audit said. "The risk is even greater when such use is not adequately controlled.''

The SBA responded that using dummy trades "cannot be avoided'' for some transactions because of the way the agency's computers are configured, and "we believe that there are sufficient procedures in place to ensure proper review'' of them.

In the 18-month period covered by the audit, the unit handled $1.1-trillion of transactions with limited oversight. One trader bet $1.4-billion in a single trade.

The audit also revealed that the unit let an unauthorized trader, a trainee, deal a total of $30-billion of securities. The unit also seemed to favor a handful of big brokers. In the audit period, 70 percent of the trades were done with only four brokers, Bank of America, Goldman Sachs, UBS and now-defunct Lehman Brothers.

In response, the SBA promised to improve paper trails, consider creating a process to review new financial products and beef up its risk-management.

Instead, they delayed finalizing the audit for 16 months, until March 2007. Meantime, the 2006 Legislature passed two bills, signed by then-Gov. Jeb Bush. One allowed the SBA to use riskier investment strategies. The other made it more difficult for outsiders to scrutinize some SBA investments.

Throughout the spring and into the early summer of 2007 — with the financial crisis already under way — the SBA continued to pump billions into risky securities.

Some of those assets plummeted in value or defaulted. As of last November, the SBA was holding about $2-billion of "distressed securities'' that were impossible to sell or could fetch only a fire-sale price.

The securities are still paying some interest, and the agency says their value will bounce back.

Robert Smith, who runs the fixed-income unit, recently told the SBA's advisory council that he felt like FSU coach Bobby Bowden after his Seminoles fumbled near the goal line in the final minute and lost to Georgia Tech.

"We got a real tail-whippin','' Smith said, quoting Bowden. "Not to make light of it, but honestly, we've been devastated.''

Still, Smith defended the trading process. "I think it is one of those outcomes that is not a very pretty outcome, but, you know, it happens ...''

• • •

By the summer of 2007, turmoil in the mortgage markets had spread to some of the securities held by the SBA.

That August, SBA staffers were told to attend risk training. They got copies of risk standards and a PowerPoint presentation.

One slide said: "A smart man learns from his own mistakes and a wise man from the mistakes of others.''

• • •

That same month, SBA executive director Coleman Stipanovich told his audit committee that he liked the scrutiny: "Some people will say, 'Oh, an audit.' You know what? I welcome audits … Bring it on! … I don't have anything to hide."

In November 2007 came the revelation that his managers were holding $2.2-billion of shaky securities. Hundreds of panicked school districts and government entities withdrew money from SBA accounts.

Stipanovich was forced to resign. For nearly a year, former Florida Comptroller Bob Milligan served as temporary steward. He tried to rebuild confidence, as the agency was hit with blistering new audits.

One was by Tanya Beder, a risk management consultant hired by the Legislature. She found the SBA's oversight and risk management procedures "sorely out of date.''

Said Beder: "When something leaks, you don't just keep watching it leak.''

• • •

Auditors in 2001, 2006 and 2007 cited a host of risks in an obscure trading strategy in which the SBA lends billions in securities belonging to the pension fund, the Florida Lottery and other funds. Auditors urged the SBA to ramp up monitoring of financial institutions involved in the loan program.

But oversight problems remained, even as the agency outsourced more work to Wall Street.

Last year, the SBA paid brokers and outside managers $300-million in fees —- about $50-million more than the year before. No independent agency checked how they earned those fees.

As the audits had warned, several lending agents invested cash collateral from borrowers of SBA assets in risky securities that have been hurt by the credit crisis. Some of those same financial institutions have lost billions.

Two months ago, without announcement, a report popped up on the SBA's Web site revealing possible losses of $506-million attributed to this trading strategy.

SigRist said the SBA did not miss any warnings; the losses were unavoidable.

A fourth audit of the securities lending program was released in November. It said, "The current financial crisis highlighted the significant reinvestment risk in what is supposed to be a low-risk securities lending program.''

It recommended another review of the program.

• • •

The $506-million was but a blip to add to the SBA's overall drop in assets confirmed in November: $62-billion, the steepest decline in SBA history.

Ash Williams, who has been executive director for three months, says the SBA's performance is in line with other big pension plans and the markets.

The agency is beefing up oversight and risk management, he says, but plans no big changes in investment strategies. They hope they can wait out the storm and hold on to devalued assets until they mature in good standing.

"The SBA has recovered very nicely from every downturn,'' Williams said in December. "This one may be longer, it may be deeper, but it will pass. I don't think capitalism is dead.'' [double sigh!]

His bosses agree. The SBA's trustees — Gov. Crist, Attorney General Bill McCollum and Chief Financial Officer Alex Sink — all say Florida has fared no worse than many big investors.

"The overall result of this pension fund is still very good — better than the norm,'' McCollum said last fall. "Will it be lower this year? Yes. But it has still been beating the market.''

Sink said in November that the pension plan has a "highly diversified portfolio'' designed for the long-term, and she has confidence in the new director.

Crist supports the SBA's decision to stay the course but sounded a cautionary note in December. "With the volatility in the stock market today, I want us to be conservative,'' he said. "I want us to be prudent, I want us to be safe and secure first with the people's money.''

Leo Kolivakis, a former senior investment analyst at two of Canada's largest pension funds, says Florida is on a "disaster course'' and it ultimately will fall to all Florida taxpayers to keep the pension fund properly funded.

"It is mind-boggling to see pension consultants recommending no major investment strategy changes for Florida's public employee pension plan although it has lost billions in the financial market meltdown,'' he said.

The SBA just got another evaluation, released last week. By Deloitte & Touche, it echoed findings about gaps in risk management in audit after audit before it. Price tag for the latest report? $198,750 and counting. A second phase by the same consultant will start soon and could cost an additional $182,500, plus expenses.

The SBA says it's a pittance and "money well spent.''

Times computer-assisted reporting specialist Connie Humburg and researcher Carolyn Edds contributed to this report.

Read the audits

Go to for highlights and Web links to 39 audits and reviews of the State Board of Administration dating to 2000. About half of them have not previously been made available to the general public.

> "The department currently lacks the tools to quantitatively evaluate the financial and risk characteristics of the real estate portfolio.'' (June 2000)

> "SBA lacks a current framework for reasonably ensuring a coordinated and efficient approach to alternative investments management.'' (September 2001)

> "The SBA needs to consider whether the expected returns from these investments are sufficient to compensate for their risks and high management costs.'' (June 2002)

> "This significantly increases the risk of unauthorized and inappropriate purchases.'' (June 2004)

> "Potentially significant risks.'' (December 2005)

> "Unacceptable and unnecessary'' risks. (March 2007)

> "With the size of the assets being managed by the SBA ... there are certain functions and additional controls that we recommend senior management consider to further strengthen the control over risks inherently taken by the SBA.'' (March 2007)

> "Significant level of noncompliance with investment guidelines and policies.'' (December 2007)

> "Significant deficiency'' (March 2008)

> "The current financial crisis highlighted the significant reinvestment risk in what is supposed to be a low risk securities lending program.'' (November 2008)

Go to for highlights and Web links to 39 audits and reviews of the State Board of Administration dating to 2000. About half of them have not previously been made available to the general public.

This excellent article should be read very carefully because I know SBA is not alone in their line of thinking, hoping that if they wait long out the storm, they will be fine. That is a risky bet to make and if they're wrong, they will continue to get punished for not taking appropriate action in their asset mix.

But it's the lack of oversight that is more worrisome. Why weren't these audits made public on their website? Why didn't they take a more conservative stance after recording some huge gains?

The answer is that they - along with many other large public pension funds - underestimated systemic risk, shoveling billions into alternative investments, and they lost big in 2008. Ultimately, it's Florida's taxpayers that will have to foot the bill for their reckless investments.