Notes to the Financial Statements

June 30, 1995

(Amounts in thousands unless otherwise stated)

Note 4

CASH DEPOSITS AND INVESTMENTS

In this note, the State's deposits and investments are classified in categories of "custodial credit risk". This is the risk that the State will not be able (a) to recover deposits if the depository bank fails or (b) to recover the value of investments or collateral securities that are in the custody of an outside party if the counterparty to the investment or deposit transaction fails. Classification in category 1 means that the exposure of deposits or investments to potential custodial credit risk is low. The level of potential custodial credit risk is higher for those deposits or investments classified in category 2, and highest for those in category 3.

Cash Deposits
At June 30, 1995, the carrying amount of the State's deposits was $(106,926) for the Primary Government and $113,427 for the Component Units. The corresponding bank balance for such deposits was $38,233 for the Primary Government and $115,796 for the Component Units. Of the bank balance for the Primary Government, $6,953 was insured by the Federal Deposit Insurance Corporation (Category 1), $3,306 was collateralized (Category 3), and $27,974 was uninsured and uncollateralized (Category 3). Of the bank balance for the Component Units, $4,565 was insured by the Federal Deposit Insurance Corporation (Category 1), $7,305 was collateralized (Category 3), and $103,926 was uninsured and uncollateralized (Category 3).

Collateralized deposits are deposits protected by State statute. Under this statute, any bank holding public deposits must at all times maintain, segregated from its other assets, eligible collateral in an amount equal at least to a certain percentage (that is, 10, 25, 100, or 120) of its public deposits. The applicable percentage is determined based on the bank's risk-based capital ratio - a measure of the bank's financial condition. The collateral is kept in the custody of the trust department of either the pledging bank or another bank in the name of the pledging bank.

Investments
According to State statutes, the State Treasurer is responsible for investing monies of State funds and agencies as well as monies of pension and other trust funds. All investments made by the State Treasurer adhere to strict guidelines on prudence, corporate governance, social responsibility and affirmative action. Investment guidelines are established by the State Treasurer with the advice of the Investment Advisory Council. Over the years, the State Treasurer has created one short-term investment fund and ten combined investment funds (including two international investment funds).

The short-term investment fund is available for investment to State funds and agencies, municipalities and public authorities. The State Treasurer is authorized to invest monies of the short-term investment fund in United States government and agency obligations, United States postal service obligations, certificates of deposit, commercial paper, corporate bonds, saving accounts, bankers' acceptances, repurchase agreements, asset-backed securities, and student loans. For financial reporting purposes, the short-term investment fund is not displayed in the combined financial statements. Instead, each fund type's investment in this fund is reported as cash equivalents in the combined balance sheet (see Note 1g).

The combined investment funds are available for investment to the pension and other trust funds. The State Treasurer is also authorized to invest monies of the combined investment funds in common stock, commercial equity real estate, foreign companies stocks and bonds, commercial and residential mortgages, foreign governments obligations, mortgage-backed securities, and venture capital partnerships. There is a restriction that not more than 50% of the investments held by the pension and other trust funds can consist of common stock. For financial reporting purposes, the combined investment funds are not displayed in the combined financial statements. Instead, each fund type's equity in these funds is reported as investments in the combined balance sheet (see Note 1g).

Certain State agencies and component units are also authorized to invest in investment contracts and state and municipal bonds.

The combined investment funds account for the purchase and sale of investments using "trade date" accounting. This means that investments are increased or decreased on the date the purchase or sales order is made although the investments are not received or delivered until a later date (settlement date). As of year end, investments under unsettled purchases are disclosed as State investments but are not categorized under categories of custodial credit risk because the investments are still in the hands of the dealers. Investments held by the State under unsettled sales are not disclosed as State investments. However, these investments are disclosed separately because they are still subject to custodial credit risk that could result in losses prior to settlement.

The schedules on the following page disclose the carrying amount and market value of the State's investments (except as discussed below) in total and by investment type as of June 30, 1995. Further, the carrying amount of these investments is classified in three categories of custodial credit risk. Category 1 includes investments that are insured or registered or for which the securities are held by the State or its agent in the State's name. Category 2 includes uninsured and unregistered investments for which the securities are held by the counterparty? trust department or agent in the State's name. Category 3 includes uninsured and unregistered investments for which the securities are held by the counterparty, or by its trust department or agent but not in the State's name.

As of June 30, 1995, the University of Connecticut Foundation, Incorporated (an affiliated organization) had investments with a market value of $62.6 million. Because the Foundation is a nongovernmental entity, it is not required to classify its investments according to categories of credit risk in its financial statements. Thus, the Foundation's investments are not included in the following investments schedules.

As of year end, the State held securities costing $221,768 (market value $221,845) under unsettled sales. These securities would have been classified under Category 1 of custodial credit risk if they were included in the investments schedule.

Derivatives GASB Technical Bulletin Number 94-1 defines derivatives as contracts whose value depends on, or derives from, the value of an underlying asset, reference rate, or index. According to this definition, the following State's investments or contracts are considered to be derivatives:

• Short-term investment fund - Adjustable rate asset-backed, corporate, Federal agency, and foreign government securities whose interest rates vary directly with short-term money market indices and are reset daily, monthly, quarterly, and semi-annually.
• Combined investment funds - Interest-only strips, collateralized mortgage obligations, common stock, future contracts, and foreign exchange contracts (interest-only strips and collateralized mortgage obligations are disclosed as mortgage-backed securities on the investments schedule).

The State invests in derivatives in order to increase earnings on investments or to hedge against fluctuations in the value of foreign currencies (as in the case of foreign exchange contracts).

The cash flow on interest-only strips is derived from the interest payments on the underlying mortgages. Therefore, these investments are very sensitive to changes in interest rates, which may encourage or discourage the prepayment of the underlying mortgages. For example, if interest rates decline, the underlying mortgages will be prepaid, thereby, reducing the cash flows from interest payments, and the value of these investments will decline. Because of the volatility of these investments, the State is in the process of gradually selling them. As of June 30, 1995, the State held interest-only strips with a cost of $12.5 million and a fair value of $5.5 million.

The common stock represents an investment in an underlying derivative consisting of a subordinated "residual interest" in a securitized portfolio of commercial mortgage loans. These loans were sold by the State to the corporate issuer who, in turn, issued bonds collateralized by the loans. The residual interest represents the difference between the principal of the underlying mortgage loans and the outstanding principal of the bonds. The underlying loans pay a fixed interest rate while the bonds pay a variable interest rate. The State is subject to the market risk that if the interest rate on the bonds increases, more of the cash flows generated by the loans will go to the bondholders, thereby, reducing the amount available to the State, and the value of the investment will decline. At June 30, 1995, this investment had a cost of $74.7 million and a fair value of $87.9 million. Also, the weighted average yield on the underlying loans was 9.44% while the variable rate on the bonds was 6.06%.

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