State of Arizona
Office
of the
Auditor General
PERFORMANCE AUDIT
Report to the Arizona Legislature
By Douglas R. Norton
Auditor General
STATE BOARD OF
DEPOSIT
December 1997
Report # 97-21
2910 NORTH 44th STREET • SUITE 410 • PHOENIX, ARIZONA 85018 • (602) 553-0333 • FAX (602) 553-0051
DOUGLAS R. NORTON, CPA
AUDITOR GENERAL
DEBRA K. DAVENPORT, CPA
DEPUTY AUDITOR GENERAL
STATE OF ARIZONA
OFFICE OF THE
AUDITOR GENERAL
December 1, 1997
Members of the Arizona Legislature
The Honorable Jane Dee Hull, Governor
The Honorable Tony West, Chairman
State Board of Deposit
Transmitted herewith is a report of the Auditor General, A Performance Audit of the State Board
of Deposit. This report is in response to a May 27, 1997, resolution of the Joint Legislative
Audit Committee. The performance audit was conducted as part of the Sunset review set forth in
A.R.S. §§41-2951 through 41-2957.
The report addresses the following three issues and recommends that the Legislature consider
amending §35-311 to: 1) provide that appointees have financial backgrounds and investment
expertise; 2) ensure that one of the two appointees also represent a local government entity
investing in the Local Government Investment Pool; and 3) change the name of the State Board
of Deposit to the State Board of Investment to more accurately reflect its actual duties.
As outlined in its response, the State Board of Deposit agrees with all of the findings and
recommendations.
My staff and I will be pleased to discuss or clarify items in the report.
This report will be released to the public on December 2, 1997.
Sincerely,
Douglas R. Norton
Auditor General
i
SUMMARY
The Office of the Auditor General has conducted a performance audit and Sunset review
of the Arizona State Board of Deposit, pursuant to a May 27, 1997, resolution of the Joint
Legislative Audit Committee. This review is part of the Sunset review set forth in Arizona
Revised Statutes (A.R.S.) §§41-2951 through 41-2957.
The State Board of Deposit was first established by statute in 1980. Currently, the Board
consists of the following five members: The State Treasurer, who acts as Chairman; the
Director of the Department of Administration; the State Superintendent of Banks; and two
individuals appointed by the Treasurer. According to A.R.S. §35-311, the Board is required
to hold regular monthly meetings for the purpose of reviewing the State’s investment
portfolio, which includes permanent endowment funds and nonendowment fund invest-ment
pools. The Board has the authority to direct the State Treasurer to sell securities
should it be deemed necessary, although it has never exercised these powers. Finally, the
Board is responsible for notifying qualified banks of the time and place at which bids will
be received to act as the State’s servicing bank when that contract is due for award.
The Board of Deposit’s periodic review of the Treasurer’s portfolio provides independent
oversight of how public monies are invested. Without adequate review and oversight of
how public monies are invested, the degree of risk associated with those investments
could be higher than the public realizes. This occurred in Orange County, California,
when the country treasurer invested public monies in high risk types of investments that
lost significant value when interest rates rose during 1994. The County was forced to de-clare
bankruptcy when investment pools decreased in value, which ultimately resulted in
a loss of $1.7 billion.
This review recommends continuing the Board. However, the audit addressed the fol-lowing
three issues and recommends that the Legislature consider amending §35-311 to:
n Provide that appointees to the Board have financial backgrounds and investment ex-pertise.
The Treasurer’s two current appointees have extensive investment expertise;
however, this is not currently required by statute.
n Ensure one of the two appointments also represents a local government entity invest-ing
in the Local Government Investment Pool. Since the State Treasurer currently in-vests
almost $2.5 billion of local government monies in the Local Government Invest-ment
Pool (LGIP), requiring LGIP representation on the Board would help ensure local
government investors have input into Board decisions. Currently one appointee repre-
ii
sents a county investing public monies with the State, but such an appointment is not
currently required by statute.
n Change the name of the State Board of Deposit to the State Board of Investment to
more accurately reflect the Board’s actual duties.
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Table of Contents
Page
Introduction and Background........................................................ 1
Sunset Factors.................................................................................. 5
Agency Response
iv
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1
INTRODUCTION AND BACKGROUND
The Office of the Auditor General has conducted a performance audit and Sunset review
of the Arizona State Board of Deposit, pursuant to a May 27, 1997, resolution of the Joint
Legislative Audit Committee. This review is part of the Sunset review set forth in Arizona
Revised Statutes (A.R.S.) §§41-2951 through 41-2957.
Board of Deposit’s
History and Mission
The State Board of Deposit was first established by statute in 1980. Currently, the Board
consists of the following five members: the State Treasurer, who acts as Chairman; the
Director of the Department of Administration; the State Superintendent of Banks; and two
individuals appointed by the Treasurer. According to A.R.S. §35-311, the Board is required
to hold regular monthly meetings for the purpose of reviewing the State's investment
portfolio, which includes permanent endowment funds and nonendowment fund invest-ment
pools. The Board has the authority to direct the State Treasurer to sell securities
should it be deemed necessary, although it has never exercised these powers. Finally, the
Board is responsible for notifying qualified banks of the time and place at which bids will
be received to act as the State’s servicing bank when that contract is due for award.
Board Reviews
Treasury Investments
The Board reviews the investment of all public monies by the State Treasurer. The Treas-urer’s
investment portfolio, limited to fixed-income securities, is currently worth nearly
$5.7 billion and includes repurchase agreements, commercial paper, collateralized mort-gage
obligations, and corporate bonds. Maturities range from overnight to 30 years. The
Treasurer currently operates 24 investment pools consisting of 13 permanent endowment
funds and 11 nonendowment fund investment pools. The permanent endowment funds
contain proceeds from sales of land that the federal government had given Arizona when
it became a state, and only the interest earnings from these funds are expendable.
Assets in the endowment funds exceeded $818 million at the end of fiscal year 1997. Each
fund has a statutory purpose. The largest fund, the Permanent Common School Fund,
contains over $750 million. The other 11 nonendowment fund investment pools, however,
totaled over $4.8 billion, with half of that amount contained in the Local Government In-vestment
Pool (LGIP). The approximately 140 LGIP participants, including counties, cities,
2
school districts, and other governmental agencies, benefit from the substantial aggregate
buying power of the state portfolio and the professional investment services the Treas-urer’s
Office provides. Other nonendowment fund investment pools include Arizona De-partment
of Transportation bond proceeds, state agency monies, and special monies for
the Arizona Game and Fish Department.
Treasury investments have been increasing rapidly. In June 1991, total assets of endow-ment
and nonendowment investments were worth approximately $2.7 billion. However,
by June 1997, total assets had more than doubled in size, to approximately $5.7 billion.
Almost $2.7 of this $3.1 billion increase in assets involves the nonendowment investment
pools. During fiscal year 1997 alone, treasury investments increased over $780 million;
approximately $391 million of this increase was experienced by the LGIP.
The Board meets monthly to review the State Treasurer’s Report, which documents the
performance of all treasury investments based on the Treasurer’s formal investment poli-cies.
In 1996, the Treasurer’s Office refined its investment policies into a more comprehen-sive
and definitive written document. In order of priority, the Treasurer is to “maintain the
maximum safety of principal, maintain liquidity to meet cash flow needs, and provide the
highest investment returns.” Currently the Board reviews investment performance against
selected financial market indices, including the Salomon Brothers Broad Investment-Grade
Bond Index, Standard and Poor’s Local Government Investment Pool Index, and U.S. Treasury
Bills. The Board also reviews investment information, such as summaries of current hold-ings,
purchases and sales, yield analyses, and cash flow projections.
Board’s Independent
Review Is Important
The Board of Deposit’s periodic review of the Treasurer’s portfolio provides independent
oversight of how public monies are invested. Without adequate review and oversight of
how public monies are invested, the degree of risk associated with those investments
could be higher than the public realizes. This occurred in Orange County, California,
when the county treasurer invested public monies in high risk types of investments that
lost significant value when interest rates rose during 1994. The County was forced to de-clare
bankruptcy when investment pools decreased in value, which ultimately resulted in
a loss of $1.7 billion.
In Orange County, the county treasurer reported to an elected five-member board of su-pervisors.
The board, who lacked sufficient financial expertise and reliable periodic in-vestment
reports, had relied on the treasurer’s previously successful investment track
record. However, a 1995 California State Audit found that the treasurer made investments
that were “unsafe, highly risky, and extremely volatile” and violated the public trust. Two
of the report’s key recommendations were to create an investment advisory committee
3
independent of the treasurer’s office, and to require the county treasurer to report to the
board of supervisors at least quarterly on investment activities and holdings. The Gov-ernment
Finance Officers Association also recommends investment committees for gov-ernments
concerned about the complexity of their investment program and the need for
an oversight function.
Recent legislation involving the Office of the State Treasurer will affect investment opera-tions,
which means that the Board of Deposit’s independent review will also be affected.
Senate Concurrent Resolution 1018, which was approved in April 1997 and which still
requires passage by the electorate during the November 1998 general election, authorizes
the Treasurer to invest in equities for the 13 state endowment trust funds. The funds are
currently invested in only fixed-income, interest-bearing instruments such as corporate
securities and U.S. Government and Agency Securities. This new equities investment leg-islation
for endowment funds was previously recommended in a 1997 Auditor General
report (Report No. 97-6) on the Arizona State Land Department. The Treasurer’s Office
agrees that equity investing for endowment funds is expected to enhance investment re-turns
by millions of dollars annually. However, this will also require the Board of Deposit
to review these additional types of treasury investment instruments.
A second bill, Senate Bill 1339, authorizes the Treasurer to lend nonendowment securities,
purchase warrant notes for cities and counties, and contract with investment advisors if
needed. Lending securities for interest earnings, and purchasing warrant notes for resale
to local governments, is expected to further enhance state treasury investment yields.
Authority to loan securities already exists in law for the endowment trusts, the Workers’
Compensation Fund, and funds of the Arizona State Retirement System. Local govern-ments
will also save money by using the State’s lower interest rates. The Board of De-posit’s
role will be further enhanced by the need to review all of these new investment
policies and procedures affecting the State Treasurer’s Office.
Audit Scope and
Methodology
The purpose of this review was to determine the need for the State Board of Deposit. Our
review recommends continuing the Board. In addition, as discussed in the Sunset Factors
(see pages 5 through 9), the audit addressed the following three issues and recommends
that the Legislature consider amending §35-311 to:
n Provide that appointees to the Board have financial backgrounds and investment ex-pertise,
4
n Ensure one of the two appointments also represents a local government entity invest-ing
in the Local Government Investment Pool, and
n Change the name of the State Board of Deposit to the State Board of Investment.
Audit work focused on evaluating the State Board of Deposit’s performance in reviewing
the investment of state treasury monies, which includes the 13 permanent endowment
funds and 11 other nonendowment fund investment pools. Relevant statutes and rules
were reviewed with regard to Board responsibilities; investment reports and other finan-cial
information from the State Treasurer’s Office was gathered and evaluated; and other
states were contacted. In addition, Board meetings were attended, meeting minutes were
reviewed, and interviews were conducted with Board members, Treasurer’s Office staff,
and other interested parties.
This audit was conducted in accordance with government auditing standards.
The Auditor General and staff express appreciation to the members of the Board of De-posit,
the State Treasurer, and staff for their cooperation and assistance throughout the
audit.
5
SUNSET FACTORS
In accordance with A.R.S. §41-2954, the Legislature should consider the following 12 fac-tors
in determining whether to continue or terminate the State Board of Deposit (Board).
1. Objective and purpose in establishing the Board.
The State Board of Deposit was established by Laws 1980, Chapter 108, now A.R.S.
§35-311. Originally consisting of the State Treasurer, who acts as Chairman, the Di-rector
of the Department of Administration, and the Superintendent of Banks, the
Board is responsible for holding public meetings each month to review the State
Treasurer’s investment of permanent endowment funds, thus ensuring that these
public monies are being invested under established guidelines. In 1996, the Legis-lature
amended this review to include all treasury monies coming into the posses-sion
or custody of the State Treasurer. The State Treasurer must invest treasury
monies in fixed-income securities authorized by A.R.S. §§35-312 and 35-313. In ad-dition,
under A.R.S. '35-311(D), the Board may order the State Treasurer to sell any
securities currently held by the State. Also, under A.R.S. §35-315(C), the Board as-sists
the State Treasurer in determining and notifying the servicing bank that had
the lowest qualified bid for the State’s banking business.
In 1987 the Legislature expanded the Board under A.R.S §35-311, adding two
members to be appointed by the State Treasurer. The primary intent in establishing
the Board remains that it act as an independent oversight of the state treasury and
has changed only to the extent that most monies today are invested in specific in-struments
rather than being deposited in a bank for overnight interest earnings.
2. The effectiveness with which the Board has met its objective and purpose
and the efficiency with which the Board has operated.
The Board has met its objective to review the State Treasurer’s investment portfolio,
currently valued at approximately $5.7 billion. The Board holds monthly public
meetings to review reports of the State Treasurer’s investments, which include
projections of cash flow requirements. These public reports, prepared by the In-vestment
Accounting Division of the State Treasurer’s Office, currently provide in-formation
on both endowment and nonendowment investment fund balances and
yields, securities purchased and sold, bank deposit collateral, and investment man-agement
fees received from local governments participating in investment pools. A
6
customized investment accounting/portfolio management system allows the State
Treasurer to account for every investment portfolio transaction, and investment ac-tivity
reports are generated daily for analysis. On a monthly basis, investments are
marked (valued) to market, a practice recently recommended by the Government
Finance Officers Association.
In addition, the Board has statutory authority to order the State Treasurer to sell
any held securities, but has never done so. However, in 1991 the Treasurer did in-form
the Board that $10 million worth of investment bonds were expected to de-fault.
The Board recommended holding the bonds and pursuing payment through
bankruptcy actions. This was done and, to date, the entire $10 million principal
amount has been recouped, including a small yield. According to the Chief Deputy
State Treasurer, the Board was instrumental in providing oversight and counsel in
this matter.
3. The extent to which the Board has operated within the public interest.
The Board has operated within the public interest by providing an independent
monthly review of the State Treasurer’s investment portfolio. To help ensure that
the Treasurer is earning appropriate rates of return, the Board reviews the per-formance
of treasury investments against the performance of selected market indi-ces
such as the Salomon Brothers Broad Investment-Grade (BIG) Bond Index, Standard
and Poor’s (S&P) Local Government Investment Pool Index, and 3-month U.S. Treasury
Bills. During fiscal year 1997 the State Treasurer earned over $303 million on all in-vested
monies, an increase from 1996 fiscal year earnings of approximately $275
million. Endowment fund earnings increased by 8.6 percent, compared to a change
in the Salomon Brothers BIG Index of 8.17 percent. The LGIP pool yield of 5.57 per-cent
also exceeded the S&P LGIP Index yield of 5.29 percent. In fact, for the first six
months of 1997 (January-June), the LGIP has outperformed the S&P LGIP Index by
an average of 0.27 percent, providing Arizona’s taxpayers with adequate returns on
invested public monies.
4. The extent to which rules adopted by the Board are consistent with the
legislative mandate.
In 1996, the Board adopted three administrative rules, all dealing specifically with
payment from the General Fund to the bank providing services to the State. Ac-cording
to the Governor’s Regulatory Review Council, these rules are within the
scope of the Board’s rulemaking authority. Since then, the Board has not adopted
any further rules.
7
5. The extent to which the Board has encouraged input from the public before
promulgating its rules and regulations and the extent to which it has in-formed
the public as to its actions and their expected impact on the public.
The Board holds regular monthly public meetings, as required by statute. Also, the
Board’s notification statement regarding open meetings is filed with the Secretary
of State and is current. However, the notification is filed under the heading of the
State Treasurer’s Office instead of the State Board of Deposit. To help ensure the
opportunity for public input in Board decisions, a separate public meeting notice
specifying the Board of Deposit should be filed with the Secretary of State and kept
current.
6. The extent to which the Board has been able to investigate and resolve
complaints that are within its jurisdiction.
Since the Board does not have investigative or regulatory authority, this factor does
not apply.
7. The extent to which the Attorney General or any other applicable agency of
state government has the authority to prosecute actions under enabling
legislation.
This factor is not applicable to the Board.
8. The extent to which the Board has addressed deficiencies in the enabling
statutes which prevent it from fulfilling its statutory mandate.
In 1987 Board composition was expanded from its original three members to five,
with the two additional members appointed by the State Treasurer. Moreover, in
1996, amendments were passed to improve operations and recognize that the
Board oversees all treasury investments, and also allowing for any loss to be
charged against earnings or capital gains, which conforms to modern investment
management practices. The Board has no legislative proposals pending.
9. The extent to which changes are necessary in the laws of the Board to ade-quately
comply with the factors listed in the Sunset review statute.
A.R.S. §35-311(A) should be amended to provide that appointees to the State Board
of Deposit have financial backgrounds and investment expertise. Additionally, be-cause
the State Treasurer currently invests almost $2.5 billion of local government
8
monies in the Local Government Investment Pool, the statute should provide that
at least one appointee represent a local government entity investing with the State.
Although the Treasurer’s two current appointees have extensive investment exper-tise,
and one represents a county investing public monies with the State, these con-ditions
are not required by statute.
Board members agree that investment knowledge and expertise are important for
Board membership. In addition, the Government Finance Officer’s Association re-cently
developed model language recommending the use of investment commit-tees
to some governments because elected policymakers may not have sufficient
qualifications to monitor an investment portfolio. The California State Auditor also
made such a recommendation in March 1995 following Orange County’s bank-ruptcy
and $1.7 billion treasury loss. Amending A.R.S. §35-311(A) to require in-vestment
expertise would help ensure that future Board members have the re-quired
knowledge to adequately review the Treasurer’s investment portfolio and
make recommendations when appropriate. In addition, requiring LGIP represen-tation
on the Board would help ensure local government investors have input into
Board decisions.
Board members recommend the Legislature consider further amending A.R.S. §35-
311(A) to rename the State Board of Deposit. They suggest a new name that would
be more indicative of the Board’s nature and its activities, such as the State Board of
Investment.
10. The extent to which the termination of the Board would significantly harm
the public health, safety or welfare.
Terminating the State Board of Deposit could potentially harm the public. Without
the Board’s independent review and oversight of treasury investments, the ap-proximately
$5.7 billion of public monies could be exposed to unacceptable levels
of investment risk. For example, the bankruptcy of Orange County’s Investment
Pool, which lost approximately $1.7 billion in 1994, had significant, far-reaching ef-fects.
The County was forced to eliminate nearly 1,700 jobs, their discretionary
budget was cut by 41 percent, public projects were delayed, and many government
services were privatized. In addition, cuts in services had a great impact on social
programs, such as children’s health care, homeless programs, and other welfare
services the County provided. Local governments and school districts who in-vested
with Orange County also experienced significant harm due to the bank-ruptcy.
The Government Finance Officers Association has determined that investment
committees make it “more difficult for an individual to initiate a program of im-
9
prudent securities transactions or unsound deposits of public funds.” The Asso-ciation
further states that by providing for collective judgments, investment com-mittees
can also be invaluable in times of crises and diffuse tension when market
losses in a portfolio may occur.
The Board’s review of treasury investments is necessary, and could become even
more important in the future. Current treasury investments are predominately
short-term in nature, which means that funds are constantly changing, and
monthly Board oversight is necessary to adequately provide for review before any
significant change in values is allowed to occur. Also, recent legislation, pending
passage by the electorate as a constitutional referendum on the November 1998
general election ballot, will allow the Treasurer to invest in equities for the state en-dowment
trusts. This authority is expected to increase investment returns. How-ever,
equity investing will require the Board to also expand its role of treasury in-vestment
oversight.
11. The extent to which the level of regulation exercised by the Board is ap-propriate
and whether less or more stringent levels of regulation would be
appropriate.
Since the Board is not a regulatory body, this factor does not apply.
12. The extent to which the Board has used private contractors in the perform-ance
of its duties and how effective use of private contractors could be ac-complished.
This factor does not apply since the nature of the Board’s activities does not call for
the use of private contractors.
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Agency Response
