Feature Articles and Resources

• Commercial Paper in Today's Credit Markets
  
• Tips for Prudent Investing in Commercial Paper
  
• How to Be Your Own Investment Adviser: Part Two
  
• Sub-Prime Mortgage Crisis Affects Florida LGIP
  
• GFOA Awards for Excellence in Government Finance
  

• Panel of Economists: Economic Outlook
  
• 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

Commercial Paper in Today's Credit Markets

By Sofia Anastopoulos, CFA

Commercial paper is a part of many government investment portfolios. Governments use it as a short-term investment that can provide diversification and competitive rates of return. This investment product has evolved tremendously since it was first developed. In light of the recent turmoil in the credit markets and the impact of this tumult on both commercial paper, as well as money market mutual funds that invest in it, an overview of this product and its different categories is timely.

Traditional Commercial Paper. Commercial paper in its basic form is an instrument issued by various entities – usually corporations - to manage their short-term liquidity and working capital needs. Historically, only entities with the highest credit ratings could issue commercial paper, which is an unsecured promissory note with a maturity of less than 270 days. Maturing commercial paper typically is “rolled over” and investors are paid off with proceeds from a new issue. Of course, the risk with rolling over is that unexpected circumstances might interfere with attempts to replace outstanding paper with new paper. To reduce rollover risk, back up lines of credit are secured for commercial paper issues. Investors perceive commercial paper to be relatively safe and liquid because of these features.

Financial innovations in the form of liquidity programs (including extendibility features, credit enhancements, as well as various special legal structures) have made commercial paper a viable financing alternative for entities with lower credit ratings. Accordingly, while investors traditionally depended on the financial strength of the issuing entity, increasingly the credit support backing an issue as well as the legal structure of the issuing entity have become an important part of the investment.

Asset-Backed Commercial Paper. Asset-backed commercial paper was a natural progression in the evolution of commercial paper and gained popularity because of concern over the instrument's unsecured status. Today, this subcategory accounts for approximately 50 percent of the commercial paper market . Put simply, in asset-backed commercial paper, certain assets and their cash flows support a commercial paper issue. Asset-backed paper is usually sold through a conduit , which is an entity established to facilitate the custody of the assets and the direction of the cash flows. Asset-backed commercial paper is considered a relatively safe short-term investment because it is secured by assets.

Multi-Seller, Asset-Backed. In general, banks establish conduits called special purpose vehicles (SPVs). The SPV is the legal issuer of such commercial paper. SPVs purchase receivables from corporate entities in a “true sale without recourse.” Thus, this structure isolates investors from corporate bankruptcies. SPVs pool the assets of many entities from various industries (multi-seller) and issue commercial paper that is backed by the cash flows from the underlying assets. In this type of commercial paper, the investor may benefit from the diversification of the multi-seller program. Typical assets include: trade receivables, credit card receivables, auto and equipment leases, and small business loans.

The sponsoring bank evaluates the assets on behalf of its SPV, provides liquidity and credit enhancement, and structures and administers the program's cash flows. This provides an alternative funding source for the bank's clients, while generating fees for the bank.

SPVs are ongoing and do not wind down (unless certain trigger events occur). Instead, maturing commercial paper is rolled over. Simultaneously, the proceeds from maturing receivables are used to buy newly generated receivables, which support the ongoing commercial paper issuance.

Single-Seller, Asset-Backed. Single-seller, asset-backed commercial paper programs are backed by the assets of one entity, for example a corporation like General Electric. The SPV in these programs buys and houses the assets of the single seller. Consequently, they lack the diversification of multi-seller programs. Often, such asset-backed commercial paper may have higher credit ratings than the seller company itself, due to the asset support and the bank credit support. However, investors should be mindful that the homogenous assets may pose concentration risk that should be evaluated.

Structured Investment Vehicle. The asset-backed market has evolved to serve a variety of needs other than the traditional funding purpose. One of these developments is the structured investment vehicle (SIV). Some SIVs take advantage of spread differentials in fixed income securities, earning interest rate arbitrage profits. Banks or hedge funds sponsor SIVs to issue relatively short-term and low-cost asset-backed commercial paper, which is used to purchase longer-term and higher yielding securities or assets. Some SIVs have extended their funding beyond the 270-day commercial paper maturity, issuing medium-term notes.

SIVs invest in various asset categories, including: mortgage-backed securities; collateralized debt obligations, which are pools of bonds and mortgages; and asset-backed securities, which are pools backed by auto loans, credit card receivables, and a variety of mortgage-related loans. Such assets are difficult to value because they do not trade on any active market. Lacking such a market, their value is based on models that are sensitive to a number of assumptions.

The turmoil in the U.S. housing and mortgage market in recent months has had a direct effect on such assets. Because of the opacity of SIV portfolios, practically all the SIVs have been unable to issue new debt or roll over their commercial paper. Forced to raise cash to pay maturing commercial paper, the SIVs have been liquidating their underlying assets, which puts further negative pricing pressure on these assets. As a side effect, investors have been frightened away from more traditional forms of commercial paper.

At the encouragement of the U.S. Treasury, several large financial institutions are in the process of forming a master liquidity enhancement vehicle (M-LEC) to help alleviate some of the difficulty encountered specifically by the SIVs in rolling over their debt. The goal is for the M-LEC to serve as a back-up liquidity facility for SIVs, which unlike other conduits, do not typically rely on bank-provided liquidity support. The sale of assets will continue. However, it is expected that the existence of the M-LEC will discourage fire sales and ease the downward pressure such sales are putting on the fixed income markets.

NRSRO Involvement. Nationally Recognized Statistical Rating Organizations (NRSRO) issue credit ratings on commercial paper. The U.S. Securities and Exchange Commission (SEC) permits these ratings to be used by other financial firms for certain regulatory purposes. For example, under SEC rules, money market funds may invest only in securities that have been rated in the top two categories of creditworthiness by an NRSRO. Money market funds also cannot invest in most asset-backed securities unless they have been rated. Investors turn to NRSRO ratings b ecause of the technical nature of such structured finance products. NRSROs are involved with the structuring of practically all SPVs and SIVs from inception, working with the sponsoring entity to determine appropriate structure, levels of liquidity, and/or credit enhancement to secure given ratings.

Money Market & LGIPs. In addition to direct investment in commercial paper, government investors are exposed to the sector indirectly via investments in money market mutual funds and LGIPs. Such funds are among the major holders of the various categories of commercial paper. To increase returns, some money market firms and LGIPs invest a portion of their funds in commercial paper issued by SIVs and backed by mortgage or real estate related assets. Although not common, certain money market funds hold SIVs that have defaulted on their commercial paper. While the vast majority of LGIPs do not hold SIV commercial paper, there are instances of such holdings.

Implications for Government Investors. Recent market events highlight the risks of commercial paper investing. The GFOA recommended practice, “Use of Commercial Paper,” recommends that governments limit their commercial paper investing to paper that has received a first-tier rating by two NRSROs . However, the due diligence and decision-making process of government investors must go beyond relying on NRSRO ratings. There are different categories of commercial paper, different legal structures for issuance, distinct funding purposes, and a wide range of asset types, levels of liquidity, and credit support. Consequently, there exists a wide spectrum of risk in the commercial paper market including default risk, counterparty risk, liquidity risk, and marketability risk. Investors of public funds must remain vigilant about what they buy. It is wise to follow old adage: “when in doubt, don't.”

Sofia Anastopoulos, CFA is a senior manager, GFOA Research & Consulting Center.

A 10-Step Plan to Becoming Your Own Investment Adviser – Part Two: Making Investment Purchases

By Kent R. Austin, CPFO

This article is the second half of a 10-step plan for keeping the investment function “in-house.” The first half, which was in the November 2007 issue of Treasury Management, presented five steps that a government should take to prepare itself for investing. This article will present five steps for making investment purchases.

There are five basic steps to the ongoing management of your government’s investments.

Step 6: Decide What to Buy. This decision involves multiple choices, such as: how much you have to invest (e.g., $1 million), what instrument to buy (e.g. Fannie Mae discount note), what maturity to seek (e.g., one year), and what you expect interest rates to do in the future (e.g., decline following Fed rate cuts). The GFOA’s publication, A Public Investor’s Guide to Money Market Instruments is a helpful resource. The following links provide GFOA guidance on specific types of investments:

• Repurchase agreements
• Money market funds
• Commercial paper
• Local government investment pools

Start with the simple question of how much to invest. An existing investment may be maturing, or your entity may have just received a large influx of property taxes. Investing in round lots like one or two million dollars at a time is straightforward and typical. Some investors look for odd-sized lots on the secondary market in the hopes of picking up slightly higher yields.

Next, compare your existing portfolio composition with your policy’s diversification requirements. If you are overweighted in government agencies, you will not want to purchase another Freddie Mac bond. Get a sense of the yields being paid on different instruments, then narrow your choice. Use Web sites like investinginbonds.com to view current rates, or contact some of your broker-dealers.

Now consider the best maturity for your purchase. This leads directly to your expectations about future interest rate changes. An expectation of falling rates suggests you should lock in current yields by going out on the curve a few years. An expectation of rising rates suggests that you should place more of the portfolio in pools and short-term securities so that reinvestment can occur at higher yields. A stable rate expectation may lead you to keep a balance between very short and medium-term holdings. Break-even analysis is a helpful tool to use when trying to decide between investments of varying length. See the December 2004 issue of Treasury Management for an excellent discussion of this topic.

Step 7: Obtain Quotes from Authorized Broker-Dealers. To purchase fixed-term investments like agency securities or Treasury bills, you will need to obtain competitive offerings from your broker-dealers. The word “offerings” is used instead of “bids,” because the broker-dealers are offering to sell you something of theirs, rather than bidding to buy something of yours.

It is best to provide advance notice to the broker-dealers you wish to use, so that they can be ready to respond to your formal request for offerings. Requesting and capturing the offerings can be done by phone, fax, e-mail, or online auction. You may provide a form of your own, such as an Excel worksheet with blanks for issuer, CUSIP, maturity date, price, and yield. Delays in receiving inbound faxes and e-mails can drag out the collection process. Since broker-dealers cannot hold their offerings firm for very long, they typically want a quick response from the city investment officer. Seeking offerings from more than three firms can complicate analysis and extend the time required to complete the purchase process. The GFOA’s recommended practice on securities dealers is a helpful resource.

Online auction products like GFOA YieldAdvantage™ are effective at assembling offerings in a uniform, timely manner. Firms are notified by e-mail of an upcoming auction and are invited to log on to a Web site to submit their offerings. Once the auction deadline is reached, the site is closed to further input. GFOA YieldAdvantage™ tabulates the results of the auction and calculates internal rates of return.

GFOA YieldAdvantage™ Example

Step 8: Compare Offerings and Select the Best One. Because multiple definitions of yield exist, investment officers must be sure they are making true comparisons. Money market yield (MMY) is often used for securities under one year, while bond equivalent yield (BEY) is used for longer investments. Discount notes and coupon bearing bonds may have the same yield but different cash prices.

Once you have selected which security to purchase, contact the broker-dealer immediately. If too much time has elapsed, you may be told that the “market has moved” and that the security can no longer be purchased at the quoted price. In this case, you either contact the next firm, accept what the original firm now offers, or cancel the entire transaction. Many times the broker-dealers not chosen will be curious to learn what you did buy; it is courteous to contact them after the selection is complete.

Step 9: Obtain Documentation and Notify your Bank and Safekeeper. Each purchase should be followed promptly by an e-mailed or faxed trade ticket from the winning broker-dealer. Verify that the details match your expectation and the offering quoted.

Trade Ticket Example FNMA Discount Note Purchase

Once you have documentation of the purchase, be sure to contact your safekeeper and your bank before the settlement date. If your safekeeper does not know of your purchase, the transaction will likely be “DK’d,” that is, rejected – “DK” being slang for “don’t know.” The day after settlement, make sure that the safekeeper has custody of the security and that your bank has debited your account for the proper amount. You should be able to obtain confirmation of both these facts online. It is a good practice to have another of your entity’s investment officers acknowledge or initial the transaction documents.

Step 10: Journalize the Transaction and Update your Records. Finally, be sure to record the purchase in your general ledger. If you are using specialized investment software, the application may have a journal entry interface. Otherwise, you or a colleague will need to write a manual journal entry. Be careful to distinguish between the purchase price of a security and any purchased interest that may be part of the total debit to your bank account. Make sure the transaction is included in your next monthly or quarterly investment report. You also may want to keep a set of chronologically ordered hanging files to store each transaction’s documents by maturity date.

Kent R. Austin is the director of finance for the City of University Park, Texas, and a member of the GFOA Committee on Cash Management.

Sub-Prime Mortgage Crisis Affects Florida LGIP

Bloomberg reports that Florida local governments pulled $12 billion out of the state-run investment pool in November (about 44 percent of its assets). About 10 percent of the investment pool’s debt holdings were downgraded below the pool’s standards. This included $900 million of defaulted debt (about 6 percent of its assets). The pool temporarily suspended withdrawals from the fund.

Below are links to several recent articles:

• Florida Halts Withdrawals From Local Investment Fund (Update3) (Bloomberg)
• Florida School Fund Rocked by $8 Billion Pullout (Update2) (Bloomberg)
• Public School Funds Hit by SIV Debts Hidden in Investment Pools (Bloomberg)

Share Your Innovation - GFOA Awards for Excellence

Share the innovation in your government by applying for a GFOA Awards for Excellence. The GFOA's Awards for Excellence in Government Finance recognize contributions to the practice of government finance that exemplify outstanding financial management. The awards stress practical, documented work that offers leadership to the profession and promotes improved public finance. Entries may be submitted for consideration in any of the following nine categories:

• Accounting, auditing, and financial reporting
• Budgeting and financial planning
• Cash management and investing
• Capital finance and debt administration
• Economic development
• E-Governments and technology
• ERP and financial systems
• Management and service delivery
• Pensions and benefits

Eight criteria are examined when considering an application for the award: local significance and value, technical significance, transferability, documentation, the cost/benefit analysis, efficiency, originality, and durability. Membership in the GFOA is not required to apply for an award; however, nonmembers and students must be sponsored by an active GFOA member. To request information about the Awards for Excellence program, send an e-mail to AwardsforExcellence@gfoa.org.

The deadline for submissions is January 15, 2008.

For your convenience, the application form and instructions are available for download from the GFOA's Web site under Award Programs.

Economic Outlook

This month, Treasury Management asked its panel of economists to provide their forecasts of the economy.

John Silvia of Wachovia Securities predicts below trend growth for the next three quarters. He expects inflation to remain within the Federal Reserve target range. Silvia predicts that the yield curve will remain steep and the Fed will lower the Fed Funds rate in the first quarter of next year.

According to Lacy Hunt of Hoisington Investment Management, the U.S. has already entered a growth recession, a situation that occurs when the economy grows at a pace insufficient to provide employment to all entrants into the labor force. Hunt notes that total household employment and household employment posted declines of 97 percent and 75 percent, respectively over the past year. In addition, a continuing contraction in the growth of total reserves and a downturn in the velocity of money suggest that monetary conditions remain restrictive. He suggests that existing the growth recession will not occur quickly or easily due to the highly leveraged condition of the U.S. economy as well as the huge volume of mortgage resets scheduled for the first half of 2008. Hunt predicts that the entire Treasury yield curve should shift downward.