June 30,1997
(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 to (a) recover deposits if the depository bank fails or (b) 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, l997, the carrying amount of the State's deposits was $6,412 for the Primary Government and $174,361 for the Component Units. The corresponding bank balance for such deposits was $145,722 for the Primary Government and $180,749 for the Component Units. Of the bank balance for the Primary Government $72,388 was insured by the Federal Deposit Insurance Corporation and private insurance (Category 1), $7,612 was collateralized (Category 3), and $65,722 was uninsured and uncollateralized (Category 3). Of the bank balance for the Component Units, $12,198 was insured by the Federal Deposit Insurance Corporation (Category 1), $2,025 was collateralized (Category 3), and $166,526 was uninsured and uncollateralized (Category 3).

Collateralized deposits are deposits which are protected by State statute. Under the statute, any bank holding public deposits must at all times maintain eligible collateral in an amount equal to 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
The State Treasurer is the chief fiscal officer of State government and is responsible for the prudent management and investment of monies of State funds and agencies as well as monies of pension and other trust funds. Investment policies and guidelines are established by the State Treasurer with the advise of the Investment Advisory Council, whose members include outside investment professionals and pension beneficiaries. Currently, the State Treasurer manages one short-term investment fund and seven combined investment funds, including one international investment fund.

The short-term investment fund is a money market investment pool which is available for investment to the State, municipal entities, and political sub-divisions of the State. The State Treasurer is authorized to invest monies of the short-term investment fund in United States government and agency obligations, certificates of deposit, commercial paper, corporate bonds, saving accounts, bankers' acceptances, repurchase agreements, asset-backed securities, and student loans. These investments are carried at amortized cost (which approximates fair value) and are included in the investments schedule.

The combined investment funds are open-end, unitized portfolios which are available for investment to 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. These investments are carried at fair value and are included in the investments schedule. There is a restriction that not more than 55% of the book value of the investments of each pension and other trust fund can consist of common stock.

The fair value of investments was determined as follows: (1) securities traded on security exchanges are valued at the last reported sales price on the last business day of the fiscal year, (2) securities traded in over-the-counter markets and securities listed on security exchanges for which no sale was reported on the valuation date are valued at the mean of bid and asked prices, (3) mortgages are valued on the basis of future principal and interest payments, and are discounted at a rate commensurate with the risk inherent in the loans, (4) real estate investments are valued on the basis of estimates provided by investment advisors, which are reviewed by State Treasurer's staff and adjusted, if necessary, and (5) investments in certain limited partnerships are valued on the basis of estimates provided by the general partners.

For financial reporting purposes, the short-term investment fund and the combined investment funds are not included in the combined financial statements. Instead, each fund type's investment in these funds is reported as "cash equivalents" or as "equity in combined investment funds" in the combined balance sheet. Complete financial information about the short-term investment fund and the combined investment funds can be obtained from financial statements issued by the State Treasurer.

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). In the investments schedule for these funds, investments under unsettled sales are included because the investments are still subject to custodial credit risk that could result in losses prior to settlement. Conversely, investments under unsettled purchases are excluded because the investments are still in the hands of the dealers.

The schedules on the following pages disclose the carrying amount and market value of the State's investments in total and by investment type as of June 30, 1997. Further, the carrying amounts of these investments are classified according to the following 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's 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 agency but not in the State's name.

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, student loan-backed revolving loans, certificates of deposit, and State of Israel securities whose interest rates vary directly with short-term money market indices and are reset daily, monthly, quarterly, and semi-annually.
• Combined investment funds - Adjustable rate and asset backed securities, indexed Treasury securities, option contracts, collateralized mortgage obligations (CMOs), common stock, and foreign exchange contracts (CMOs 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).

CMO's are bonds which are issued by a special purpose trust and which are collateralized by an underlying pool of mortgage loans. The bonds pay interest at fixed or variable rates and have stated maturity dates. Interest payments on the bonds are made in accordance with the trust indentures and amounts received from borrowers in excess of interest payments and expenses are used to amortize the principal on the bonds in order of their stated maturity. Because mortgage prepayments are largely dependent on market interest rates, the ultimate maturity of the bonds is unpredictable and is sensitive to changes in interest rates, but is generally prior to the stated maturity date. As of June 30, 1997 the State held CMOs valued at $220.3 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 (the CMO residual). 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, 1997, the CMO residual had an estimated fair value of $95.3 million, and the weighted average yield on the underlying loans was 10.63% while the variable rate on the bonds was 5.72%.

Foreign exchange contracts are used to facilitate transactions in foreign securities and to manage the funds currency exposure. Contracts to buy are used to acquire exposure to foreign currencies, while contracts to sell are used to hedge the funds' investments against currency fluctuations. Losses may arise from changes in the value of foreign currencies or failure of the counterparties to perform under the contracts' terms.

Security Lending Transactions
Certain of the combined investment funds are permitted by State statutes to lend its securities through a lending agent to authorized broker-dealers and banks for collateral with a simultaneous agreement to return the collateral for the same securities in the future.

During the year, the funds' lending agent lent securities similar to the types on loan at year-end and received cash (United States and foreign currency), securities issued or guaranteed by the United States government, sovereign debt rated A or better, convertible bonds, and irrevocable bank letters of credit as collateral. The funds' lending agent did not have the ability to pledge or sell collateral securities delivered absent a borrower default. Borrowers were required to deliver collateral for each loan equal to: (1) in the case of loaned securities denominated in United States dollars or whose primary trading market was located in the United States or sovereign debt issued by foreign governments, 102% of the market value of the loaned securities; and (2) in the case of loaned securities not denominated in United States dollars or whose primary trading market was not located in the United States, 104.5% of the market value of the loaned securities. In the event any borrower fails to return the loaned securities or pay distributions thereon, the funds' lending agent is contractually obligated to purchase replacement securities, or return the cash collateral. At year end, the funds had no credit exposure to borrowers because the amounts the funds owed the borrowers exceeded the amounts the borrowers owed the funds.

All securities loans can be terminated on demand by either the funds or the borrowers. Cash collateral is invested in the lending agent's investment collateral pool, which at year-end had a weighted-average maturity of 35 days. A percentage of the investment collateral pool is invested in overnight instruments and money market mutual funds to enable it to meet normal liquidity needs.

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