Feature Articles and Resources

• Understanding GSEs
  
• What are U.S. Government Instrumentality Securities?
  
• U.S. Government Agencies and Instrumentalities Obligations
  
• Investment Strategies for the Current Environment
  
• GFOA Investment Training

• Panel of Economists: Economic Forecasts
  
• Interest Rate Outlook
  
• Economic and Interest Rate Data

• Performance Benchmarks
  • 10-Bill Index
  • Money Market Fund Index
  • LGIP Index
  • Key Rates: Cash Markets
  • Relative Value Yield Chart

Understanding GSEs

Over the past several years, much attention has focused on government-sponsored enterprises (GSEs). Specifically, the focus has been placed on the housing GSEs: the Federal Home Loan Bank System, Fannie Mae, and Freddie Mac. Their recent growth and accounting problems have drawn the attention of the media and Congress. Concern over their role in the unprecedented housing appreciation throughout the United States and the broader repercussions of this have heightened concern further.

The purpose of this article is to provide an update on the housing GSEs as well as the often-overlooked non-housing sector, including the Federal Farm Credit Banks (FFCB), the former GSE, Sallie Mae, and the Tennessee Valley Authority (TVA).

Overview. GSEs are entities created by Congress to promote specific policy goals, such as home ownership, education, and farming. The various GSEs assist groups of borrowers by facilitating access to capital markets. Often divided into the housing and non-housing sectors, GSEs lack the explicit backing of the U.S. government, but are tied to it as federally chartered entities that carry a credit line with the U.S. Treasury.

In practice, there exists some confusion over agencies and GSEs. Agencies alone are backed by the full faith and credit of the government. As such, they carry federal guarantees to pay the face amount and periodic interest payments on their securities. However, while lumped as agencies by laymen and seasoned investors alike, the securities of the GSEs do not carry such a guarantee. Rather, the perception of low risk stems from the implied guarantee, bolstered by the view that these entities are too intertwined with the health of the overall economy to be allowed to fail.

The Housing GSEs. Tremendous growth, combined with accounting problems and allegations of management misconduct have lead to spirited debate on the proper scope and regulation of the housing GSEs. One drastic perspective questions whether the housing GSEs have outlived their usefulness and should simply be privatized. However, even complete privatization does little to eliminate the systemic importance of these entities. Another alternative is a centralized regulatory structure for the housing GSEs. Nonetheless, such a change or centralization of GSE regulation might emphasize the government’s direct involvement with the GSEs instead of minimizing the implied guarantee. Proposed regulatory changes include: higher capital requirements, limits on borrowing, elimination of funding subsidies, refocus on policy purpose and product lines, requiring more transparency and greater disclosures.

Federal Home Loan Banks. Created in 1932, the FHLB consists of 12 regional banks, owned by private member institutions. The FHLB system extends credit through its member banks in order to provide access to housing. The central FHLB Office of Finance issues these debt instruments on a consolidated basis. Recently, after some well-publicized accounting and management issues, the SEC encouraged the 12 FHLB to register their stock, which is not publicly-held but owned by FHLB members, with the SEC. This does not affect the FHLB debt securities, which government investors purchase. However, registration is intended to focus the banks and the system more on risk management and accounting policies and procedures, and make them more transparent. Going forward, the practical outcome of this change will be that quarterly and annual financial statements as well as periodic reports, will be available to the public via the EDGAR database. As of February 2006, only five of the FHLB had registered with the SEC, with two more expected to become effective shortly.

Fannie Mae. A publicly held company, Congress created Fannie Mae in 1938 to promote home ownership by providing a secondary market for housing loans. Currently, it is regulated by the Secretary of Housing and Urban Development (HUD) and Office of Federal Housing Enterprise Oversight (OFHEO).

Fannie Mae’s unprecedented growth from the early 1990s sparked concern for this GSE. More recently, accounting practices, risk management operations and general management practices have received media attention. The Rudman Report, an internal review prepared by former Senator Warren Rudman, was released in February 2006 and concluded that Fannie’s accounting practices were inaccurate and not consistent with GAAP.

In 2003, to heighten control and transparency, Fannie Mae voluntarily registered its common stock with the SEC, consequences of which include filing periodic financial disclosures with the SEC via the EDGAR system and becoming subject to SEC review and enforcement authority. This registration does not change Fannie Mae’s exempt debt securities.

Freddie Mac. Like Fannie Mae, Freddie Mac is a public corporation, established by Congress in 1970 with the explicit goal of providing a continuous flow of funds to mortgage lenders. HUD and the OFHEO also regulate Freddie Mac. Recent financial reporting issues caused regulators to impose a 30 percent capital surcharge on Freddie Mac pending its return to timely reporting and accurate capital measurement. In 2002, like Fannie Mae, Freddie Mac agreed to register its stock with the SEC, filing periodic reports, available via the EDGAR system. This will serve to improve corporate governance, financial reporting, disclosure and investor confidence.

Recent trends place FHLB, Fannie Mae, and Freddie Mac as the largest GSE issuers of both short- and long-term debt. The long-term debt of each of these issuers is rated AAA, with the short-term rates A-1+.

Non-Housing GSEs. TVA. Often labeled agency and GSE, the Tennessee Valley Authority (TVA) is unique. A wholly-owned agency of the U.S. government, the TVA is a self-supporting entity whose debt is not guaranteed by the government, but supported strictly by TVA revenues. Created in 1933 to provide electric power and promote economic development in the Tennessee Valley region, the TVA has a statutory debt limit of $30 billion. Unlike other GSEs, the TVA does not issue stock and its finances are typically included in the annual federal budget. In accordance with legislation proposed in the 2007 budget, the TVA will begin registering its debt securities with the SEC in a move towards greater transparency. Currently, there is some debate whether TVA may have outlived its agency charter and should become a privately-held corporation.

FFCB. The oldest GSE, the Federal Farm Credit Banks Funding Corporation (FFCB) consists of a nationwide network of borrower-owned lending institutions that lend to agricultural and rural America. FFCB banks do not accept deposits, but rather obtain their funds through the issuance of a variety of debt securities. While total issuance is much smaller than that of the housing GSEs, FFCB securities tend to be popular among investors. Recently, there has been discussion of including the Farm Credit System in any regulatory reform as a way of risk reduction and standardization of regulatory practices and standards, along with SEC registration for its lending institutions.

The Federal Agriculture Mortgage Corporation, Farmer Mac, was created by Congress to attract new capital to finance agricultural real estate and provide liquidity to agricultural lenders. Regulated by the FCA, Farmer Mac arose out of the FFCB as a system entity responsible for its own debt obligations. Trading mainly in discount notes, Farmer Mac is limited to $5 billion in debt outstanding at any point. Accordingly, its issues may not provide enough liquidity for many investors.

Sallie Mae. After successfully completing a privatization process in December 2004, Sallie Mae is no longer a GSE, but a fully private organization. Originally established in 1972 to help students access higher education, Sallie Mae facilitates a secondary market for student loans. As part of the privatization process, a trust was created to defease any remaining GSE liabilities. However, all debt issued after this date is the sole responsibility of the corporation. Terminating the GSE charter was based on the belief that privatization would not affect Sallie Mae’s overall value but instead allow it to expand and diversify its businesses.

Sofia Anastopoulos, CFA, is manager of GFOA YieldAdvantage. Morgan Shipley is associate manager, GFOA YieldAdvantage.

Investment Strategies for the Current Environment

Current Environment

Inflation and growth are the major topics in the market at this time. Where the Fed will go from here seems to be dependent on economic data, and it is very difficult to make a clear determination based on the current data available.

• The most recent (March) Core CPI reading revealed that prices had risen more than expected.

• Growth remains strong and earnings also have been strong in the most recent quarter. The median estimate of first quarter GDP growth is 5.0 percent.

• Employment remains strong. The most recent report from the Bureau of Labor Statistics showed the economy added 211,000 jobs and the unemployment rate settled in at 4.7 percent. The economy has averaged gains of 171,000 jobs a month since January of 2005, which promotes the health of the economy as a whole. However, employment growth can also be a sign of potential inflation if the growth is a reaction to excesses in demand not met by current supply.

Prudent Investment Strategies

For investors in the money market space, this market environment continues to be challenging. The Fed’s most recent minutes suggest that the Fed is much closer to its endgame with the most recent tightening. However, one could argue that because the economy is as strong as it is, the Fed has some cushion to continue tightening short-term rates. The market feels there is a strong probability of the Fed hiking rates at its May 10 meeting, but is unsure that further rate hikes will be necessary. Given this uncertainty, what is a prudent measure to take at this time?

• For the remainder of the first half of 2006, investments inside of three-months remain the preferred maturity as the tightening cycle continues. The one-month part of the curve will likely be the most attractive. There remains some steepness in the longer portion of the money market curve (nine- to 12-month area) that could provide a good hedge. Shorter dated floaters could also be a safe play to mitigate any concerns for those investors that believe the Fed still has room to move.

• For the second half of this year, public investors should find that the prudent strategy is to extend portfolio weighted average maturities since the money market curve is expected to flatten out. Extending the portfolio's weighted average maturity, or duration, could be even more important due to the propensity for a period of Fed tightening to be shortly followed by a potential Fed easing as early as the first quarter of 2007, based on where the market is pricing in fed funds futures today.

Byron Gehlhardt is a portfolio manager for MBIA Asset Management Group. The opinions expressed in this article are solely those of the author, are based upon sources of information believed to be reliable, and are subject to change without notice.

GFOA Investment Training

The GFOA will hold two investment seminars in September and October 2006 to meet the needs of both experienced investors and those who are newer to public investing.

Advanced Public Investing. This year’s Advanced Public Investing seminar will be held on September 20-21 in Sacramento, California. The seminar will cover the following topics:

• Risk concepts and metrics
• Measures of return
• Benchmarking portfolio performance
• Passive portfolio strategies
• Active portfolio strategies
• Options-adjusted spread analysis
• Electronic tools for portfolio management

It is strongly recommended that participants attend the GFOA Investing Public Funds seminar before attending this Advanced Public Investing seminar.

Investing Public Funds. For those who are newer to public investing, or those who would like to strengthen their knowledge of the fundamentals of sound investing, the GFOA will hold an Investing Public Funds seminar on October 23-24 in Hartford, Connecticut. This seminar will cover the following topics:

• Framework for a sound investment program (an investment policy, safekeeping, broker/dealer due diligence, investment procedures and internal controls, and portfolio reporting)
• Investment instruments
• Understanding investment risks and GASB 40 requirements
• Investment strategies (cash flow forecasting, rising and falling interest rate strategies, and yield curve analysis)
• Investment advisors

Further information and online registration, is available check GFOA's Web site.