Inside This Issue
September 1, 2006
Volume 24, Number 9

Feature Articles and Resources

Economy and Interest Rates

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

How to Use Collateralization to Safeguard Public Deposits

By M. Corinne Larson, CTP

The safety of public funds deposited with banks and other depository institutions has been a primary concern of government finance officers. Governments typically entrust depositories with millions of dollars in checking accounts, savings accounts, and certificates of deposit. Hundreds of depository institutions failed in the late 1980s and early 1990s. These bank failures highlighted the need to pay careful attention to protecting government deposits beyond the $100,000 limit provided by the Federal Deposit Insurance Corporation (FDIC).

Since that time, the health of the country’s financial institutions has greatly improved. Today, consolidation of commercial banks into fewer larger companies has changed the face of the banking industry. Although banks are more diversified and less exposed to regional economic downturns, risk of bank failure remains. A recently released GFOA publication, An Introduction to Collateralizing Public Deposits, presents concrete steps that governmental entities can take to protect their deposits in today's banking environment. Highlights from this publication are presented in this article.

Collateralization Practices. Most states have enacted statutes that either require or permit depositories to pledge collateral securities to secure public deposits. Typically, high-quality government securities (such as U.S. Treasury obligations, federal agency securities, and municipal bonds) are pledged to protect those funds. When a collateralization program is used in conjunction with other risk-control policies and techniques, finance officers can significantly improve the safety of their deposits.

How Collateralization Works

The flowchart below illustrates how collateralization and third-party safekeeping work. The government places deposits with its depository bank and enters into a security agreement that formalizes the public entity's relationship with the bank. The depository bank transfers securities through the Federal Reserve System to a third-party bank that acts as custodian.

The depository bank and the custodial bank enter into a custodial trust agreement that ensures the securities held by the custodial bank show the government as the owner of those securities. The custodial bank will send the government a monthly statement listing the securities being held as collateral and reporting the market value of those securities.

Source: Banking Services: A Guide for Governments, GFOA.

There is a five-step process for establishing a collateralization program.

Step 1: Review State Collateralization Laws. Finance officials should review their state statutes and discuss the law with local legal counsel. In addition, finance officials must make sure that each step outlined in the statute is carefully followed. The state statute should be considered the minimum requirement. Finance officials may wish to exclude eligible collateral or institute higher collateralization ratios for securities that are long-term, illiquid, or have a lower credit rating.

Step 2: Identify Depository Risk Exposure. Public officials often find that demand deposits are difficult to collateralize because of fluctuations in cash flow. Some governments use “sweep” accounts or other similar vehicles to ensure that funds are automatically invested in repurchase agreements or money market mutual funds on an overnight basis. If a block of collateral securities is used to protect demand deposits, the finance official should study the maximum risk exposure that occurs during cash flow peaks. Governments whose peak cash balances significantly exceed their collateral levels should enact policies that acknowledge this problem and require their banks to adjust the collateral accordingly.

Step 3: Establish a Written Depository Collateralization Agreement. In 1995, the GFOA Committee on Cash Management developed a sample security agreement and custodial trust agreement for governments to use for collateralizing deposits. (Both of these documents are in the new GFOA publication An Introduction to Collateralizing Public Deposits.) GFOA encourages governments to develop and enter into depository collateralization agreements even if state law assigns this responsibility to the state. A written agreement helps assure enforcement of collateral protections. Such agreements should include the following elements:

  • Funds to be Collateralized. This section should address demand and time deposit accounts and should discuss the overlap or offset of federal deposit insurance.

  • Eligible Collateral Instruments. Sometimes this is dictated by state law, but in some cases a public entity may wish to allow only certain instruments in order to assure liquidity and marketability. As noted in the collateralization ratios paragraph below, certain instruments involve greater risks and should be collateralized at higher levels. If a bank fails, the depositor will receive the collateral securities in lieu of the deposits. A good rule of thumb is to only accept securities as collateral that the entity would be comfortable holding in its own investment portfolio.

  • Market Value. At least monthly, the market value of collateral securities should be calculated and the collateral adjusted because the face value of securities generally is not the true market value. This practice, known as marking-to-market, may be done as often as daily. One of the primary reasons for determining market values is that interest rates, a major determinant of market values, rise and fall continually. In a rising interest rate environment, bank collateral could drop in market value and reduce the government’s protection.

  • Collateralization Ratios. Many states establish a single ratio by which the value of the collateral must exceed the deposit. (Sometimes this is referred to as a “haircut,” or “excess margin.”) However, the risks associated with different instruments vary, and a collateralization margin schedule should be inserted in the agreement to reflect those different risks and liquidity characteristics. Securities with greater credit risk or long maturities should be collateralized at a higher ratio. (This issue includes suggested collateralization ratios to be used in a monthly mark-to-market program.)

  • Safekeeping Procedures. Public deposits are best protected by collateral that is held in safekeeping by an independent third party. To accomplish this, the securities can be held at the following locations:
    1. A Federal Reserve Bank or its branch office. Public investors must understand that the Fed is the “bankers’ bank.” The Fed’s client is the depository, not the government jurisdiction seeking collateral. However, Federal Reserve safekeeping procedures can provide for independent control of collateral, and frequently two signatures are required before assets can be released in an event of default. (Note: Federal agencies and the Governmental Accounting Standards Board have stated that they interpret this form of deposit pledging to be the equivalent of delivery to the investor.)

    2. Third-party collateral safekeeping can be arranged at another custodial facility. Most banks maintain “correspondent” relationships with independent commercial banks that can hold a government’s deposit collateral in safekeeping. A written safekeeping agreement should document this safekeeping relationship. Such third-party safekeeping assures independence and reduces the chance for fraud. However, this arrangement may be more costly than safekeeping at a Federal Reserve Bank. Generally, third-party safekeeping should be held in a trust department through book-entry at the Federal Reserve (unless physical securities are involved).

    3. The trust department of a commercial bank can hold the collateral in safekeeping. This procedure is usually cost-effective, but should be substantiated by a written trust agreement as a way to discourage fraud and to ensure the existence of an impenetrable boundary between the bank”s operations and trust departments.

  • Substitution. If the depository wishes to substitute one form of collateral for another, the agreement can permit this, so long as the substituted securities meet the depositor’s requirements and approval. (Sometimes a depository may need a specific collateral security for trading purposes, and such substitutions are not imprudent as long as the new collateral meets the depositor’s standards.) Governmental entities must approve the substitution of collateral in order to have a perfected (ownership) interest in the pledged securities as required by Uniform Commercial Code 4A. Pledged collateral securities should not be released until the substituted collateral is received in order to maintain control.

  • Monthly Statements. Monthly statements of collateral are necessary to ensure adequate monitoring, and should be prepared on a market value basis to help the finance officer verify the adequacy of collateral. Without such information, it may prove difficult to effectively monitor the collateral program. Some governments obtain an independent market valuation on the collateral securities to ensure that the market value calculated by the depository is correct.

Step 4: Establish Effective Safekeeping Procedures. The process of developing a suitable collateralization agreement requires considerable time, legal review, and discussion with interested parties. The three primary methods of safekeeping are discussed above in Step 3, and may require remedial action if current practices are deficient.

Step 5: Prepare for Financial Reporting Disclosures. In March 2003, the Governmental Accounting Standards Board (GASB) issued Statement No. 40, Deposit and Investment Risk Disclosures, an amendment of GASB Statement No. 3 (for a summary of this statement see GASB Statement No. 40 eliminates many of the cumbersome reporting requirements of Statement No. 3, although governments must still disclose depository risk for deposits that are not insured or properly collateralized. In their annual financial statements, governments must report deposits that are uninsured and uncollateralized or if the collateral securities are held by the same financial institution holding the deposits, according to GASB Statement No. 40. Some governments may decide to avoid financial statement disclosures that are difficult to explain and will therefore elect to provide for third-party delivery of deposit collateral. As noted in Step 3, this can be accomplished efficiently through the Federal Reserve System.

Summary. Deposit collateralization is one of several important risk control procedures that should be used by prudent public cash managers. Although the process of establishing a sound collateral program may be complex, the effort is worthwhile. It may also be desirable to have stronger collateralization requirements than those required by the state statute.

M. Corinne Larson is a vice president with MBIA Asset Management Group and can be reached at 914/765-3505.

Suggested Collateralization Ratios to Be Used in a Monthly Mark-to-Market Program
Form of Pledged Collateral
Collateral Ratio
U.S. Treasury Bills, Notes, and Bonds
  • Maturing in less than 1 year
  • Maturing in 1-5 years
  • Maturing in more than 5 years
  • Zero-coupons Treasury securities (STRIPS etc.) with maturities exceeding 10 years
Actively Traded U.S. Government Agencies
  • Maturing in less than 1 year
  • Maturing in 1-5 years
  • Maturing in more than 5 years
U.S. Government Agency Variable Rate
GNMA Mortgage Pass-Through Securities
  • Current issues
  • Older issues
  • Issues for which prices are not quotes
Other Federal Agency or Mortgage Pass-Through Securities
Collateralized Mortgage Obligations and Real Estate Mortgage Investment conduit Securities
Municipal General Obligation Bonds (**)
  • Maturing in less than 1 year
  • Maturing in 1-5 years
  • Maturing in more than 5 years
Municipal Revenue Bonds (***)
  • Maturing in less than 1 year
  • Maturing in 1-5 years
  • Maturing in more than 5 years
105 - 110%
110 - 120%
120 - 130%

Source: An Introduction to Collateralizing Public Deposits, Second Edition, GFOA.

*Mortgage securities, such as CMOs and REMICS, carry a high degree of market risk and the market prices of these securities can be volatile in periods of rising interest rates. For this reason, high collateral ratios such as 125 percent should be considered.

**General obligation bonds refer to bonds issued by an in-state unit of government. Out-of-state municipal bonds may require a higher collateralization ratio unless their credit ratings are in the highest investment grades (e.g., AAA or AA).

***Lower investment grade revenue bonds (A or BBB) should be collateralized at higher ratios. Industrial development revenue bonds may not be acceptable due to credit quality, unless guaranteed by a third party. High credit ratings should be demanded if such bonds are pledged for collateral.

Useful Resources on Collateralization

Other Forms of Prudent Risk Control

In addition to deposit collateralization, public investors have developed several techniques to control the risks of their cash and investment portfolios. Many of these approaches represent a preventative approach to safeguarding government assets, minimizing the government's risk exposure and reducing the likelihood that the collateralization “tool” will ever be called upon in a crisis. Below is a brief list of these techniques.

  1. Formal Credit Analysis. Public cash managers are strongly encouraged to study carefully the financial condition of depository institutions. To accomplish this task, several indicators and quantitative tests can be used. Credit rating agencies and many independent bank rating agencies provide ratings of commercial banks and savings and loan institutions.

  2. Minimizing Demand Deposit Levels. Instead of maintaining compensating bank balances, many state and local governments invest their cash directly in money market instruments, using a sweep account or a zero-balance account program to reduce their demand deposits. Depositories then are paid directly for services.

  3. Written Policies for the Investment Program and for Banking Relationships. As part of a prudent, well-designed cash management program, written policies can provide useful controls.

  4. Investing in Fully Secured Instruments.
    • Direct ownership of liquid U.S. Treasury securities.
    • Placing CD deposits through the Certificate of Deposit Account Registry Service (CDARS). CDARS provides a means of obtaining FDIC insurance for CD deposits of up to $25 million.
    • Properly documented repurchase agreements with depository institutions generally are better protected and more liquid than interest-bearing deposits.
    • Local government investment pools, operated by state officials or under state supervision or by a private investment manager, offer another avenue for prudent investing.
    • Money market mutual funds whose portfolios consist of full-faith-and-credit U.S. government securities also can be used as a safe, liquid alternative to bank deposits.

For more information on other forms of prudent risk control see: An Introduction to Collateralizing Public Deposits, Second Edition, GFOA.

Economy and Interest Rates
Panel of Economists
Interest Rate Outlook





Fed Funds 5.30

5.25 - 5.30

5.25 - 5.30

5.00 - 5.30
30-day prime bank (CD) 5.30

5.30 - 5.35

5.30 - 5.33

4.95 - 5.30
3-month T-bill yield 5.10

5.00 - 5.20

4.90 - 5.30

4.65 - 5.30
5-year Treasury note 5.00

5.00 - 5.10

4.90 - 5.20

4.80 - 5.20
30-year Treasury bond 5.10

5.05 - 5.20

4.90 - 5.20

4.80 - 5.20
Consensus Index* 100% 100% 100%
The Public Investor's panel of eminent institutional economists projects interest rates for the first day of each forecast month. Averages are the midpoints between the arithmetic mean and the median of individual projections. The low and high individual forecasts illustrate the range.

Consensus index is the percentage of responses within 75 basis points (0.75 percent) of the average interest rate. Index measures the extent of panelists' agreement. If all forecasts are with 3/4 percent of the various averages for a given month, the consensus would be 100. If all responses fall at the extreme ends of a wide range, the index is 0.

Interest rate forecast panelists
Avery Shenfeld CIBC World Markets
John Silvia Wachovia Securities

Gary Thayer

AG Edwards & Sons, Inc.


Middle East Conflict and the Economy

This month Public Investor asked its panel of economists what effect the conflict between Israel and Hezbollah will have on U.S. economic growth, inflation, and interest rates. After about a month of fierce fighting, both sides have agreed to a cease-fire that will be enforced by a multinational peacekeeping force.

The economists agreed that the conflict will have little impact on the U.S. economy. John Silvia of Wachovia Securities states that the conflict will have a small negative effect on growth as long as energy prices remain elevated.

Lacy Hunt of Hoisington Investment Management agrees that the effect on the U.S. economy should be minimal unless the conflict spreads to Syria and Iran. Gary Thayer of A.G. Edwards adds that the conflict does not appear to be threatening Middle East oil supplies.

Economic Outlook. The most recent Federal Reserve Survey of Professional Forecasters predicts more moderate economic growth in the months ahead, with GDP averaging 2.9 percent in the fourth quarter and 2.8 percent in 2007. The survey predicts that CPI inflation will average 3.3 percent in 2006 and then fall to 2.6 percent in 2007.

Interestingly, the survey predicts a 20 percent probability of a recession in 12 months (the median among 46 forecasters). This is a relatively high percentage for this survey and suggests a weaker consensus among economists over the strength of the economy 12 months from now.

Snapshot of Economy and Interest Rates

Economic Summary




Economic Growth      
Real GDP growth
Annual rate, constant dollars
II Q '06
I Q '06
Year Ago
Retail sales
$ billions
Year Ago
Industrial production index
Change, monthly and annually
12 mo. chg.
Leading indicators index
Change, monthly and annually
6 mo. chg.
- 0.1%
New housing starts
Thousands of units, annualized
Year Ago
Purchasing Management Index
Institute for Supply Management
Year Ago
Consumer price index
Change, monthly and annually
12 mo. chg.
Producer price index
Change, monthly and annually, seasonally adjusted
12 mo. chg.
GDP price deflator
Annual rate
II Q '06
I Q '06
Year Ago
Unemployment rate
Year Ago
Money market fund

Average portfolio maturity
(Money Fund Report Averages TM)
Aug 15
38 days
July 18
36 days

Aug '05
36 days

Moving Averages
6-Month Treasury Bill

2-Year Treasury Note

10-Year Treasury Note

Investment Performance Benchmarks
The Public Investor 10-bill index
Quarterly/Monthly Return
Annualized Returns Since
Jan.1, 2005
Jan. 1, 2004
Jan. 1, 2005

1.93% (Q)

Jan. 1, 2006


July 1, 2006
Aug. 1, 2006


Sept. 1, 2006
The money market fund index
Annualized Returns Since
Average Return
Jan.1, 2005
Jan. 1, 2004
Jan. 1, 2005 1.46%
0.76% 0.82%
Jan. 1, 2006 3.51%
2.47% 1.29%
July 1, 2006 4.52%
2.99% 1.70%
Aug. 1, 2006 4.66%
3.07% 1.77%
Sept. 1, 2006 4.80% 3.15% 1.84%
S&P Rated LGIP Index
7-day yield
30-day yield
Maturity (Days)
August 18 , 2006
Key Rates: Cash Markets
Rate 8/25/06 Year Ago
Fed funds 5.26 3.55
CDs: Three months 5.35 3.81
CDs: Six months 5.43 4.02
BAs: One month 5.29 3.62
T-bills: 91-day yield 4.98 3.46
T-bills: 52-week yield 5.07 3.87
Commercial paper, dealer-placed, 3 months 5.28 3.60
Bond Buyer 20-bond municipal index 4.34 4.25
Tax-exempt notes 3.55 2.96
Relative Value Yield Chart

Moving Averages - Public Investor's four-week moving averages are calculated as a simple average of Friday closing yield quotations for the most recently offered six-month Treasury bill (discount basis), two-year Treasury note, and 10-year Treasury note. Moving averages are used by analysts to monitor trends and trend changes. Generally, interest rates are increasing (prices falling) when the moving average yield is rising and the current rate exceeds the moving average. Conversely, current yields below a declining moving average are associated with lower interest rates (high prices on fixed-income securities). Some market timers buy (or sell) longer maturities when current market yields fall below (or penetrate above) their moving averages.

The Public Investor 10-bill index - This index consists of 10 hypothetical Treasury bill investments, with an average maturity of approximately 80 days. Every other Thursday, a T-bill matures and proceeds are reinvested alternately in the three-month and six month T-bills. This rolling index provides a benchmark for evaluating cash management portfolios with biweekly payment and payroll requirements. The original value of the index was 97.6765 on July 1, 1984.

The money market fund index - This index is the simple average of Money Fund Report Averages ™ seven-day money market fund indexes, as reported for the two weeks closest to the end of each month. The annualized return is calculated using these rates for a four-week period centering on the first of each month. The results should simulate returns from passive investment in an average money market fund.

S&P Rated LGIP Index
- This index is comprised of local government investment pools that are rated AAAm or AAm by Standard & Poor's and represents pools that strive to maintain a stable net asset value.

Executive Director/CEO Jeffrey Esser
Editor R. Gregory Michel

The Treasury Management Newsletter is published monthly by the Government Finance Officers Association (GFOA), 203 N. LaSalle Street, Suite 2700, Chicago, IL 60601. (312/977-9700; email: Annual subscription rates are $55 for active GFOA members, $70 for associate GFOA members, and $85 for nonmembers. For reprint permission contact GFOA.

The information and opinions printed herein are from sources believed to be reliable, but GFOA makes no guarantee of accuracy. Opinions, forecasts and recommendations are offered by individuals and do not represent official GFOA policy positions. Nothing herein should be construed as a specific recommendation to buy or sell a financial security.

Government Finance Officers Association of the United States and Canada
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