A feud between state auditor Marion Higa and Gov. Linda Lingle grew more heated yesterday with Higa challenging the administration to take a lie detector test.

At issue are more than $1 billion in state investments in student-loan-backed securities that have declined in value by about $250 million over the past several years. The state won't necessarly lose that money, because the principal will be paid back in full if the investments are held until their maturity.

However, Higa said yesterday that state purchases of so-called auction rate securities violated the law and put state funds at increased risk.

According to a report released by the auditor yesterday, the investments didn't comply with state laws and policies that require diversity of investments, that investments maintain a AAA rating and that short-term investments mature in less than five years.

The audit, which covered the Department of Budget and Finance from July 1, 2008, to June 30, 2009, said the agency lacked leadership and accountability and is not effectively managing the state's $3.8 billion treasury.

Earlier this month, Lingle harshly criticized a draft version of the report, calling it "shoddy," "unprofessional" and "politically motivated." The governor also called on state lawmakers to investigate Higa.

Higa yesterday said she and others within her office would be willing to take a lie detector test to prove their veracity.

"If the administration will do the same, we'll see where the truth might lie," Higa said.

Higa took the unusual step of releasing the results of the audit at a news conference yesterday in which she criticized Lingle's administration and Department of Budget and Finance officials who made the investments.

"I believe that the administration's attack on our reputation and our credibility deserves some unprecedented attention," Higa said. "I think we need an affirmative response to set the record straight.

"The behavior of the administration has also been unprecedented. I believe it reflects a lack of integrity."

Lingle yesterday was unavailable to comment on the audit.

In a written response attached to the audit, Georgina Kawamura, the Budget and Finance Department director, said the report includes inaccurate , misleading and false statements. She also expressed concerns that the audit's allegations of a lack of leadership and accountability could hurt the state's reputation.

"We are concerned that this baseless conclusion may damage Hawai'i's hard-earned reputation as a prudent manager of public resources and adversely affect our ability to sell bonds," Kawamura wrote.

The main issues raised in the audit resulted from a rise in the popularity of auction-rate securities as "near cash equivalents," investments that can be easily and quickly converted into cash. The rate of return on auction-rate securities is typically higher than for comparable investments. However, the liquidity of the securities evaporated when the auctions began failing last year as dealers hamstrung by subprime losses pulled back from purchase guarantees and credit markets started to tighten.

CASH CRUNCH

The state shifted large amounts of its investments into the bonds even as the auction rate market started to tighten in second half of 2007, because of their high rate of return. The investments were legal and in line with an opinion by the state attorney general, according to the state.

However, those yield -driven purchases were in conflict with state policies that emphasize safety and liquidity of investments over yield, Higa said.

Money tied up in auction rate securities reduces the state's potential cash reserves, could affect the state's ability to meet future cash needs and could potentially be a factor behind state plans to delay income tax refunds , she said.

"It's very obvious the state is in a cash crunch," she said. "Having the billion dollars frozen like this presents a cash crunch. Whether we might still have to delay tax refunds is a possibility even without the billion dollars being frozen, but it exacerbates the situation."

The audit recommended that the state formalize polices and procedures and improve cash and investment management practices , including doing a regular review of investment policies.

Kawamura agreed with some recommendations, but maintained that the audit's main findings were unsubstantiated and lacked merit.

"The result of the review is an undeserved attack on the hard-working men and women of this department," she wrote.