Legislation Expands Use of CDARS for Investment Risk Management

An increasing number of governments now have a means of protecting deposits in excess of the $100,000 FDIC limit—without collateralizing those deposits or using a portfolio of depositories. During the first eight months of 2004, several states have opened the door for local governments by passing enabling legislation and adopting legal clarifications.

Through a new service called the Certificate of Deposit Account Registry Service®, or CDARS® (pronounced “cedars”), banks can offer their customers up to $5 million in federal deposit insurance coverage on deposits placed through one bank. For government finance officers, CDARS offers the safety of FDIC insurance with the convenience of one rate, one regular statement, and one banking relationship. Equally important, in most states, FDIC-insured deposits do not require collateralization.

CDARS can be used for CDs with 4-, 26-, 52-, 104- and 156-week maturities. CDARS would not apply to overnight investments.

How CDARS Works. Members of Promontory Interfinancial Network—a network of FDIC-insured institutions—allocate a customer’s deposit (in the form of CDs) among several network banks so that all funds are eligible to be insured by the full faith and backing of the federal government. (Technically, deposits placed through CDARS meet the pass-through insurance coverage guidelines established by the FDIC.)

For example, suppose a city needs to invest $1 million. The city uses a competitive bidding process to obtain rates from several local banks. Because the winning bidder is a member of the CDARS network, the city is able to deposit the entire amount with full FDIC insurance coverage through the winning bank. The money is divided into amounts less than $100,000 and placed in CDs issued by other network members through CDARS. The city receives regular consolidated interest payments and statements from the bank showing the account activity for each CD held in its name. In addition, the bank receives funds from other network members' customers totaling the amount deposited by the city.

The 550-plus banks that comprise the CDARS network exchange deposits on a dollar-for-dollar basis. In other words, the amount of money a bank places using the CDARS service returns to that bank in the form of customer money from other network members. These reciprocal deposits among banks usually qualify funds placed using CDARS as “local,” a requirement of many government investment policies. At the end of the day, the bank has the deposit on its books that can be used for community lending purposes.

Depositors do not pay to use the CDARS service; the rate of CDs placed through CDARS is negotiated like any other CD.

CDARS Benefits. Almost all states have enacted statutes that require public deposits in excess of the FDIC's $100,000 limit to be secured by pledged collateral securities from depository institutions.

Before CDARS, the drawback of obtaining FDIC insurance for finance officers was the limit of $100,000 per depositor, per institution. Even so, many governments choose to spread their deposits among dozens of banks rather than deal with the inconveniences of monitoring and managing collateral.

Because CD deposits placed using CDARS are eligible for full FDIC insurance coverage, governments investing through CDARS are not required to track collateralized assets and constantly mark-to-market the prices of Treasury bills and other pledged assets, which makes investing easier and less time-consuming. For government cash managers, this means not having to deal with multiple banks, rate renegotiations, and collateral monitoring.

Because statutory requirements for the investment of public funds vary from state to state, governments must make sure that CDARS qualifies as an appropriate investment tool. Some may need to update their investment policies to permit the use of this new service.

Legislative Status. Last month, Illinois became the fifth state in 2004 to enact legislation to enable finance officers to invest through the CDARS service. The legislation in Illinois was an initiative of the Community Bankers Association of Illinois. Missouri, Colorado, Nebraska, and South Dakota enacted similar legislation earlier in the year, and bankers in other states worked for passage of legislation, as well. Under these 2004 enactments, government finance officers may invest public funds through CDARS only by placing the funds through a CDARS-participating bank located within the state.

Also during this year, Kansas, New Hampshire, and Hawaii through legal interpretation enabled governments to use CDARS.

Finance officers in Alaska, Connecticut, Georgia, Kentucky, Maine, Minnesota, Nevada, Oklahoma, Pennsylvania, South Carolina, Tennessee, Vermont, and possibly a few other states have been able to use CDARS for investment of public money under existing authority. No legislation was required in these states for local governments to use the CDARS service.

Efforts led by bankers and their associations are underway to obtain legislative or interpretative clarifications in virtually all of the remaining states. (The network has members in all 50 states, the District of Columbia, and Puerto Rico).

Deposits from public units accounted for 25 percent of Promontory's transaction volume, based on recent statistics.

Conclusion. For local finance officers, collateralization of deposits has proven to be a generally effective protection against bank failures, but collateralization imposes a significant administrative burden on them. CDARS offers a convenient alternative to collateralization by expanding access to Federal deposit insurance to up to $5 million of coverage. 2004 legislation will significantly expand this alternative to more localities across the United States.

Mark Jacobsen is president and chief operating officer of Promontory Interfinancial Network. For more information about CDARS, please contact Promontory at either contact@promnetwork.com or 866/776-6426.

Panel of Economists

Health Care Costs Slow Employment Growth

Despite three years of economic growth, growth in employment continues to be sluggish. Public Investor asked its panel of economists if rising health care costs are restraining employment, and what are the main factors behind the slow growth in employment.

Carl Tannenbaum states that rising health care costs are a definite impediment to full-time hiring. Another key contributor to the slow growth in employment is very strong productivity growth.

Lacy Hunt highlights three factors that have caused the slow growth in employment. The first factor is the “bubble” economy of the late 1990s that resulted in excessive investment in plant, equipment and office buildings. The second factor is a large inflow of lower priced imported goods due to excessive over-investment in foreign capacity combined with poor demand in foreign countries. The third factor is the unprecedented type of uncertainty and caution due to the threat of terrorism. This uncertainty has directly damaged the tourism industry, which, in the past, has contributed significantly to employment growth.

John Silvia states that a rise in the relative cost of labor to the cost of capital has slowed employment growth. Rising health care costs have increased the cost of labor, while depreciation has lowered the cost of capital. Neal Soss agrees that rising health care costs are part of the story behind the slow growth in employment. Other “parts of the story” are the continuing adjustment of corporate leadership to the crises in corporate governance, and the oil price shock, which has reduced the willingness of businesses to increase employment.

Growth May Be Slower Than Expected

New data suggest that the economic recovery may be growing at a slower pace, caused in part by high oil prices. In the most recent Survey of Professional Forecasters, conducted by the Philadelphia Fed, forecasters reduced their forecasts of economic growth from three months ago. The current survey predicts that the GDP will grow at a rate of about 3.8 percent for the second half of this year (down from 4.1 percent), and an average rate of 3.7 percent next year (down from 3.9 percent).

The forecasters also see higher inflation than they did three months ago. The forecasters revised their forecast of CPI inflation from 2.7 percent to 3.4 percent for the fourth quarter of 2004. The forecasters kept their forecasts for unemployment at an average rate of 5.5 percent for this year and 5.3 percent for next year.

RGM

Fed Raises Rates Again

At its most recent meeting on August 10, the Federal Reserve Open Market Committee decided to raise the Fed funds rate 25 basis points to 1.5 percent. The Fed stated that “the economy appears poised to resume a stronger pace of expansion.” Many Fed watchers expect the Fed to raise rates to 2 percent by the end of 2004 and 3 percent by the end of 2005.

The most recent Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, predicts that the three-month Treasury bill will increase to 1.8 percent by the fourth quarter of 2004, and 2.9 percent by the third quarter of 2005, while the 10-year Treasury bond will increase to 4.8 percent by the fourth quarter of 2004, and then to 5.5 percent by the third quarter of 2005.

RGM

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