Tentacles of subprime crisis reach to Duluth's rainy-day fund

DULUTH -- The city's reserve fund -- often called the piggy bank or rainy-day fund because its money is used only in emergencies -- has been left precariously low after a bad investment tied to a subprime mortgage lender.

If the city were financially healthy, it would have about $8 million in the reserve fund, or a little less than 10 percent of the general fund budget. Though that's never happened, the city does have a policy that at minimum the fund should be about 5 percent of the general fund, or $4 million, Duluth finance director Genie Stark said.

In fact, the fund has about $1.6 million, or about 1 percent of the general fund balance, with about $1 million of that specified as undesignated.

"If there's a bump in the road somewhere, it could be devastating," City Councilman Todd Fedora said. "How would we pay for an emergency?"

The fund balance is also crucial when the city borrows money for a project, because investment firms such as Moody's and Standard & Poor's look at the reserve fund when assigning ratings to a borrower. On July 24, the city plans to bond for more than $40 million to finance the Duluth Entertainment Convention Center expansion.

"If you don't have a cushion, they charge more interest," Councilman Jim Stauber said. "Even a fraction of a percentage point change can cost taxpayers tens of thousands of dollars."

City officials said they are working to correct the problem. Stark said that by the time the city has its ratings calls -- about a week before the July bonding -- a new budget plan submitted by Mayor Don Ness, outlining a strategy for budget cuts and revenue increases, probably will be approved by the council.

The city found itself in this situation because it tapped the reserve fund to pay for a loss in a 2007 investment in Mainsail II, an investment that offered short-term returns and was backed in part by investments in subprime mortgages.

At the time of the investment, Stark said, Mainsail II had A+ ratings from S&P and Moody's. However, when the city treasurer became concerned with problems in the market, Stark said, the city went to sell its holdings in Mainsail II but was told there was no market for it.

The city's $3 million investment has since shrunk by about $1.9 million, Stark said.

Both Stauber and Fedora say they're angry they were only told about the problem Thursday night when Stark presented the information to the Council, even though the city knew of the problem last summer.

"I don't know if that's by accident or if they chose not to tell us what was going on," Stauber said.