Feature Articles and Resources

• Investment Management in Smaller Governments
  
• Investment Tips and Traps for Smaller Governments
  
• Washington Update
  
• Liquidity Assessments: A Cost-Effective Alternative to Bank Liquidity Facilities

• Panel of Economists: Mid-Term Elections
  
• Interest Rate Outlook
  
• Snapshot of Economy and Interest Rates

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

Investment Management in Smaller Governments

Smaller governmental entities have a unique set of needs and requirements in their investment portfolios. Unlike larger entities with investment staffs, advanced technology, and a core portfolio of longer-term funds, small entities face a number of difficulties. Internally, the smaller entity often does not have staff that can spend extended time working solely on the investment portfolio. The smaller entity is usually an infrequent investor, which adds to the difficulty of following market trends. Traditionally, the smaller entity's governing board is extremely conservative and risk adverse and the portfolio is closely tied to the banking contract. Additionally, the securities market (the "street") prefers large dollar trades, which can leave smaller entities with less attractive price levels. These barriers can be discouraging for a smaller entity which wants to be just as "state-of-the-market" as larger entities and needs the incremental income of a producing portfolio as much as any size government.

It often seems that large entities conduct a completely different kind of investment program from smaller entities and work in a completely different market. Larger entities often have access to larger size trades and longer maturities because of bond funds or reserves. However, underlying fundamentals and investment processes used by the largest portfolios are also available to the smallest of portfolios. The fundamentals of safety and the techniques used are essentially the same. Smaller entities simply have to learn the basic rules, evaluate what alternatives are appropriate, and build on those fundamentals to form practical strategies.

What Makes a Small Entity's Investments Unique? The smaller entity's unique needs and limitations are primarily a function of cash flow needs and market access. A small entity normally does not have substantial excess funds that can be extended out the yield curve and thereby earn the extra yield afforded those who can take that risk of extension. If budgets and fund balances are normally spent within a single fiscal year, the smaller entity must assure that dwindling funds are available for cash flow needs. Liquidity becomes foremost in importance and vies, with safety, for first priority in your investment objectives. These two factors will normally limit the smaller entity to investment options within a one-year or 18-month investment horizon.

The need for liquidity must be the over-riding consideration of small entities. No entity can afford to lose its ability to pay creditors. As a result, cash flow analysis and the application of those findings become the first step in building a portfolio. A cash flow analysis will determine the amount of funds necessary within the general time horizon. The cash flow may also identify "core" funds, which will not be needed within the normal one-year time frame and thus can be extended (in a normal yield curve environment) for additional yield.

There are other factors, which make a smaller entity unique for investment purposes. Staff resources are often limited by inadequate training or use of a small staff for a multitude of other responsibilities. In addition, the pace of the bond market and the variety of influences on it, make access to market information and investment technology crucial. No portfolio can be expected to take full advantage of market potential unless the investor has access to the necessary data and time to make appropriate and accurate decisions on that information.

Investment Tips and Traps for Smaller Governments

Most of the fundamentals of investing apply to both large and small entities and represent common sense and common practice. It is important to remember not to get caught up in the technical aspects of trading or portfolio structuring and forget these fundamentals. One example of this is the old axiom: "If it sounds too good to be true, it is!" No investor can afford to forget this or the other fundamentals that keep safety and liquidity our most important objectives.

• Nothing is Free! When it comes to investments and banking it is critical to remember that every firm must make a reasonable profit. Banking services are never "free." The rates you receive on other services or interest rates on CDs will reflect the cost. Likewise, a money manager who offers to manage your funds without charge makes his money on the mark-up. Brokers who offer to safekeep your securities or provide "soft-dollar" services free receive their mark-up on the trade also. Remember the only way to pay for anything with public funds is by competitive bid. Separation of responsibilities and disclosure of information is critical. (For more information, see the GFOA recommended practice “Selection of Investment Advisers for Non-Pension Fund Assets.”)

• Diversification in All Things! Requirements for diversification inculcate all aspects of investing. This reflects the sage advice that you should not put all your eggs in one basket. Diversification in the types of securities you own will protect your entity from credit risk or major changes in one type of security. Set policy limits by market sector and credit. Diversification by maturity is important to assure that you have liabilities covered in preparation for a change in market direction. (See the GFOA recommended practice “Diversification of Investments in a Portfolio.”) Diversification in brokers is also critical. You should never depend exclusively on a single broker. Regardless of how good that broker is, he is dependent on one economist and one trading desk and knows you are not gathering competitive bids/offers. Using several brokers will assure that you see value from several different sources. (See the GFOA recommended practice “Government Relationships with Securities Dealers.”) Always get competitive bids or offers – especially on CDs.

• An Investment Policy is Paramount in Importance! Before you do any investing, you should have an investment policy approved by your governing body. Your policy establishes the objectives and limitations of your investing activities and protects you the investor. The policy will guide all of your activities and set needed controls. (For more information, see the GFOA Sample Investment Policy.)

• Create a Cash Flow Foundation! It is impossible to determine what investments need to be made without a solid cash flow analysis. Cash flow analyses need not be complicated or time consuming. Your general ledger and bank statements will provide all the details and data you need to put a history of revenue and expenditure cash flows together. The time you spend will reward you by allowing you to stretch out slightly further on the yield curve. You may even identify a "core" portfolio of money that can be extended beyond your one year horizon. The cash flow will also help you set your maximum maturity and weighted average maturity which are critical controls against over-extension. (See the GFOA recommended practice “Use of Cash Flow Forecasts in Operations.”)

• Pricing Your Portfolio is a Must! Since many portfolios holding derivatives lost significant market value in the mid-90s as rates increased, market value has become a more visible concern to governing bodies. An investor must know the portfolio's worth (the amortized book value) even if securities were bought with the intent to hold to maturity. Marking-to-market a portfolio simply means assigning a market price to each security based on independent and accurate prices. (See the GFOA recommended practice “Mark-to-Market Reporting Practices for State and Local Government Investment Portfolios and Investment Pools.”) One easy way is to stay with securities that can be priced from the Wall Street Journal. If you use brokerage firms, be sure to receive two prices. If a security is difficult to price, never use the firm that sold you the security as the sole source for the price quote.

• Delivery versus Payment! Perhaps one of the key safety requirements in investing is Delivery versus Payment (DVP). You must always have access and control over all of your assets or your cash. You must clear every trade DVP which assures that your independent clearing agent has control at all times for you. You can only do this if you have an independent custodian holding your securities. Never use broker safe-keeping.

• Safekeeping! Safekeeping by a contracted, independent third party will assure that you know where your securities are and that your ownership is perfected. Never allow brokers to safe-keep for you. The ownership of the securities becomes blurred in a bankruptcy or interruption of service. Pay a bank or trust company. It is well worth the cost.

• Don't Buy Bonds that will Mature after You Do! It is a good rule to always buy bonds and other securities as if you can hold them to maturity. Although sometimes it looks like a 'sure thing' on a callable or that you can sell a security at a future date, if you cannot sell it without a dollar loss you must be able to hold that security without creating a liquidity crisis. (See the GFOA recommended practice “Maturities of Investments in a Portfolio.”)

• Banking and Investing are Two Separate Processes! For many years, public entities relied on bank contracts to form the basis of their investment strategy. The markets have become much more sophisticated and alternatives much too attractive to do so now. Do not tie your investing options to your banking contract alone or by setting a rate on CDs, etc. Let your bank know that you will include them in competitive bids as you look for relative value.

• When in Doubt - Don't! The market moves quickly and is very inventive. New products and terms are constantly popping up. It is safest to stay with what you know and slowly work on learning more. Ask questions until you feel comfortable. (For more on this topic, see the GFOA recommended practice “Use of Derivatives by State and Local Governments for Cash Operating and Reserve Portfolios.”)

Washington Update

By Susan Gaffney

Muni Investment Practices Questioned by Federal Government Agencies. In November, the IRS Criminal Investigation Division, the Federal Bureau of Investigation, the Department of Justice’s Antitrust Division, and the Securities and Exchange Commission (SEC) announced concurrent federal, criminal, and civil investigations regarding guaranteed investment contract (GIC) bidding practices within the municipal bond sector. More two dozen GIC brokers, insurance companies, and financial institutions have been subpoenaed for documents related to transactions between 1992-2006, with at least three GIC brokers’ offices having been raided in November. News reports state that the investigations are looking into anticompetitive bidding processes or kickbacks and fee arrangements that were left undisclosed. These price fixing or collusion practices could be illegal under the Sherman Antitrust Act and may constitute securities fraud. (Bond Buyer, Nov 17, 2006, “Wide Ranging Probe”). The subpoenas also asked for information relating to forward supply, purchase, or delivery agreements; repurchase agreements; swap; and swaptions. No state and local governments have thus far been implicated in this far-reaching and unprecedented investigation into the reinvestment practices of the municipal bond sector.

State and local governments invest bond proceeds in guaranteed investment contracts until the funds are needed to be spent on a particular project. Unlike other segments of the municipal bond marketplace, GICs, as well as derivatives and swaps, are not regulated by the SEC nor the Municipal Securities Rulemaking Board. For years the Internal Revenue Service’s Tax-Exempt Bond Division has been reviewing and auditing reinvestment practices (because they relate to yield restriction regulations). However, believing criminal activities may be occurring, the IRS alerted the other branches of governments of their findings.

Current Treasury regulations dictate that issuers must receive at least three independent bids for their investments (GICs), and many issuers hire GIC brokers to find the best opportunity for their jurisdiction. One of the practices that might be unearthed is agreement among different parties for one bid to be given as a true bid, but the other two bids be given in an unrealistic manner, thus the contract could only be awarded to the party providing the true bid.

State and local government officials and other marketplace participants are concerned about the broad scope of the investigations, and the possible violations that may have occurred that would cause harm to the vital tax-exempt bond market and/or lead to overreaching action by Congress.

The Chairman of the GFOA’s Governmental Debt Management Committee Patrick Born (CFO of the City of Minneapolis) stated, “We need to carefully examine whether there is appropriate transparency in the way the municipal bond business is being done in these areas. The municipal (bond) market is very important to state and local governments and with this investigation it may be tainted. It’s important that everybody who benefits by and supports this market take steps to improve transparency in every transaction – not just the pricing of bonds, but the investment of bond proceeds, derivatives and related financial products.” (Bond Buyer, November 22, 2006, “Market Shocked at Justice’s Reach”).

With the GIC bid rigging investigations just being announced in November, this will be a developing issue that will require constant monitoring by GFOA staff and its members throughout 2007.

New Congress. Washington is abuzz with the results of the November elections. New leadership will be installed in January and it is uncertain if banking legislation of interest to state and local governments will be addressed in 2007. Since Congress tackled long-awaited FDIC reform in 2006, it is unlikely that another significant overhaul of FDIC practices will take place in 2007. This is unfortunate because local governments have looked to possible increased amounts for insured municipal deposits (as was included in House legislation, but not agreed to in the final FDIC Reform bill passed by Congress). The House proposal would have increased municipal deposit insurance levels to the lesser of $2 million or the standard issuance amount plus 80 percent of the deposits over that amount. Current insurance amounts for municipal deposits are the standard amount ($100,000), which will be adjusted for inflation beginning in 2010.

Other issues of interest to local governments that the GFOA Federal Liaison Center is monitoring include:

• Allowing Federal Home Loan Banks to provide credit support to tax-exempt bonds. While legislation was introduced in 2006 (S. 3657 and H.R. 5177), it was not given attention by the committees that have jurisdiction over this matter, i.e., the House Ways and Means Committee and Senate Finance Committee. It is likely that the legislation will be reintroduced in 2007.
  
• Continued review of hedge fund practices by Congress and the Securities and Exchange Commission. The Senate Banking Committee held hearings throughout 2006 regarding the practices of the hedge fund industry and the Committee’s intention to “continue its active role in overseeing the (hedge fund) industry’s activities and regulatory structure.”
  
• Tax exempt bond law. GFOA and other state and local government associations will be promoting changes and simplifications to current tax-exempt bond law, including the need for the bank qualified debt limit to be increased from its current level of $10 million to $25 million. The $10 million limit was set in 1986, and simple inflation calculations demonstrate that $10 million in 1986 is equal to around $17 million today. Thus, there is a significant need to increase the limit to better assist local governments with their financing needs.
  
• Credit card fees. We are continuing our work with the National Association of State Auditors, Comptrollers and Treasures (NASACT) regarding the reduction or elimination of interchange fees charged by credit card companies to state and local governments for government tax and fine charges.

For more informationabout the activities of GFOA’s Washington office and our 2007 Legislative Agenda, please visit the Federal Government Relations page of the GFOA's Web site.

Susan Gaffney is the Director of the GFOA Federal Liaison Center.

Liquidity Assessments: A Cost-Effective Alternative to Bank Liquidity Facilities

Liquidity assessments were introduced to provide debt issuers with a cost-effective alternative to traditional bank liquidity facilities for the provision of liquidity support for variable rate debt instruments. Issuers have indicated that bank liquidity facilities are often expensive and can be cumbersome to administer.

• An analysis of the liquidity, market risk, and volatility of the issuer’s current cash, fixed-income portfolio holdings, risk management, and operations;
  
• An assessment of management’s plans to provide cash (i.e., its liquidation plan) including a current maximum dollar assessment of the issuer’s ability to raise cash or provide liquidity on its own; and
  
• Monthly monitoring of key portfolio and related data to ensure sufficiency and liquidity of assets.

Who Can Take Advantage of Liquidity Assessments? Creditworthy tax-exempt debt issuers with “excess” available and highly liquid assets sufficient to meet all debt obligations on a full and timely basis can use their own “liquid assets” to provide liquidity support for commercial paper and variable rate demand obligations tenders.

During the past few years, more than 40 municipal issuers from all public finance sectors have sought to use these pools as back-up liquidity support for their short-term debt issues. Issuers with liquidity assessments are diverse, ranging from smaller institutions such as University of Vermont, to larger government entities like the State of Texas.

What Does the Issuer Get?

• A letter (at least annually) affirming the issuer’s sufficiency of assets to cover liquidity obligations;
  
• Ongoing surveillance of the issuer’s cash and fixed-income portfolios ensuring that the assessment of the liquidity profile is up-to-date;
  
• Feedback from analysts regarding the availability of liquidity for current or future proposed short-term debt issuance;
  
• A description of the issuer’s liquidity profile and the rating agency’s rationale for the short-term rating supported by self-liquidity.