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As published by the International City Manager's Association 2/96 MIS Report
Investments and cash management are an increasingly important part of financial management in the private and public sectors. Governmental entities must fully utilize their assets. Every governmental entity can improve its cash management function and risk containment and has real incentive to do so. Even in a relatively low interest rate environment, a well managed cash management program and its investment portfolio can generate the substantial incremental earnings needed by that entity. Although cash management and investments should never be seen or operated solely as a "true profit center" it does indeed generate "profits not taxes"!
Improving the return on investments can entail some risk. And although there is risk in every aspect of cash handling that risk can be minimized so cash management becomes risk management.
The cash management function follows the flow of funds through an entity. Every governmental entity charges for certain services and functions. Billing for those services and functions is where the cash management function begins.
Just as important however, is the need to activate your internal processes to speed the flow of cash into your portfolio for investment purposes. Receivables themselves highlight an important difference in cash management. Receivables have too often been delegated to the accounting function. These important assets are recorded, forgotten and eventually written off: the ageless receivable! Accounting by its nature is charged with maintaining historical records. The cash management function however looks forward. Cash managers are always working on tomorrow's cash or tomorrow's security settlement. This complementing difference between the two functions can be used to your entity's advantage as natural checks and balances.
Banking is a key to cash activation. A viable banking structure can consolidate your assets and create larger balances for investment. Your banking should not be intrinsically tied to investments.
Another key to effective cash management is cash flow analysis. No investment portfolio can be properly structured until the entity has a functioning cash flow analysis process. Only in this manner can liquidity requirements be effectively met.
Finally, security is a large part of cash management. Collateral, contracts, and custody form the foundation of safety for all assets of the city.
Only when these key elements of cash activation and security are in place can we turn our attention to the investment portfolio. As with the other elements of cash management, before the portfolio can be structured, a solid foundation must be built to reduce the various types of market, credit and liquidity risk.
The cash management process continues after the investing is done. The final responsibility of the process is to oversee the timely outflow of funds. The actual task, often delegated to accounting, assures a separation of responsibility. The cash management emphasis however should be to assure that timely discounts are taken and payables are not paid before the due date.
This then encompasses the three major areas of cash management: cash activation, security and investments, and disbursement. This report will examine each area separately in the context of the overall cash management function. We will look at cash management for its important potential contribution to the bottom line of government today.
CASH ACTIVATION
In order to activate cash most governments need to start with their contact
with the citizens: the billing cycle. Historically, there is a need for
government to become more aggressive and businesslike with both billings and
receivables.
Cash activation mandates that every step in the flow of cash be evaluated for efficiency and effectiveness. Billing, receivables, cashiering, depositing, and banking must be reviewed to assure that funds are flowing as expeditiously as possible to your portfolio where it is then available for investment purposes. Cash can not be earning interest if it is not available for investment.
Especially in the public sector, we have traditionally done a poor job on billing and collections management. Since it has not been considered as part of an entire cash management arena, it has lacked continuity. Since it was identified as a recording keeping function it did not receive priority. This perception has changed as budgets have tightened. Technology has given us terrific opportunities to create new approaches to collections and billing. Through these changes, improvements of well over 100% in returns are possible and probable.
The Concept of Float
Cash management is float management. Everything we do is to control and/or
reduce float. If a check sits in a clerk's work basket for three days the
funds are being used by the payee not you. If it takes an additional three days
to clear a check the payee is still using the float. Float refers to the time
that funds are paid but not available to you. Cash management analyzes the
entire flow of funds to reduce the float in the process.
There are three types of float which must be reduced: mail float, processing float and clearing float. The mail float is the time delay on an invoice before it is sent or the delay in receiving the payment through the mail. The processing float is the time it takes to process and deposit that payment to the bank. The clearing float refers to the time a check takes to clear through the banking system.
Measuring Float
Float is measured in dollar-days (time lag in days x the amount delayed =
dollar-days).
The average daily float is measured in monthly intervals (dollar days/# days in
period).
The cost of float is interest lost because funds are not available.
Billing
Every government entity bills for some of its many services. Unfortunately,
this process is rarely reviewed. More often than not, government bills only
once and bills separately for each of its many services because of its
traditional departmental structure. There is rarely a coordinated billing
process and little standardization of bills. Bills and billings however must
get the customer's attention. Billings need to be clear, concise and current.
Technology now allows for cost effective printing and repetitive billing systems which allow the governmental unit to stay in front of their customers. The new technology also allows us to cut operation and development time and costs and produce a better more functional product that will actually increase collections.
Laser printing technology available, internally or externally, allows even the smallest government to reduce billing cost and usually effectuate better collection rates. The high volume printing directly from computer tapes reduces internal print shop costs and delays. Coupled with mailing services which sort bills and utilize mail discounts such a process can significantly reduce staff and capital costs as well as speed the billing itself. This is particularly effective for repetitive billings such as utilities or large periodic billings for taxes. Printing can be made on a generic (standard) city form which then is customized from the database information.
If a lockbox is to be used for collections, the bill is printed with a magnetic coding strip (MICR encoded) with all the account information necessary for scanning the document on its return. (See lockboxes below.) For example, a city, through such a credit card process, would simply produce its computer generated tax information tape. Utilizing an outside printer and mailer for handling, the bills would be printed and mailed. A bank lockbox would receive, process and deposit the funds and the city's only costs would involve receiving a second computer tape of deposits to be applied to its database. Many cities, such as Fort Worth, Texas have used such a process to significantly reduce staff costs while reducing all three types of float.
Such a process can be expanded effectively for use with coordinated billings from several different departments - especially for aged receivables.
Coupon books are another effective means for handling repetitive billings. Any repetitive fee or charge, such as leases, payment plans, etc., can utilize a coupon book which, when printed outside, significantly reduces costs. The coupon book can be customized for the entity and stays in front of your customer and remains a priority to him. Costs are dramatically reduced because the process is done once not twelve times in a year. Coupon books can be standardized and may even contain return address stickers and general city information for costs as low as $1.00 a book plus one-time postage.
| Monthly Billing | = 12 x Staff preparation time + Computer Time + Printing + Postage |
| Coupon Book | = 1 x Staff preparation time + Computer Time + Printing + Postage |
The use of an outside contractors can dramatically reduce or eliminate the paper handling and capital equipment costs associated with billing. In addition, if the entity uses one standardized billing format for centralized receivables billings, the citizens recognize and react to the billing. Billings studies tell us that if billings are frequent and current the customer is more likely to respond.
Attention to the billing needs of the entity will reduce receivables and boost earnings through funds available for investment. By improving billing and staying in front of the customer the entity reduces the possibility that the entity's current bill becomes the entity's aged receivable.
Receivables
Governmental receivables in general are not actively pursued for collection.
They are usually relegated to an historical accounting function rather than an
active collection function. As a result, the receivables are simply aged and
eventually written off. But as government moves from a preponderance of funded
programs to fee supported activities, the issue of accounts receivable
management will become more and more important. The size of receivables will
rise and the criticality of controlling the impact of receivables will
increase.
A study of the impact of aged receivables is a lesson in the tremendous impact on your revenues. For example:
If your rolling monthly receivable totals $ 100,000 your annual loss of revenue can be as high as $104,996. This $100,000 receivable is left to age in a 5% interest environment for 30, 60 and 90 days and then written off resulting in a loss of interest and principal.Receivables are a process not a product. Through their active management we definitely mobilize funds and reduce float. Coordination into one database for billing and collection can improve customer files in departments. For maximum efficiency collections and credit management systems should be integrated. This process further improves access to information on cash flows and supports audit trails throughout the system. Regardless of the degree of centralization possible, the key to reducing receivables is a followup in collections.
Adding administrative costs to handle, age and report on that receivable raises the cost even higher.
$100,000 @ 5% for 30 days = $416 $100,000 @ 5% for 60 days = $833 $100,000 @ 5% for 90 days = $1,249 A final write-off of the $100,000 = $100,000
Collections
A review of annual write-offs will indicate how many resources should be used
to focus on this receivables problem. You do not want "aged" receivables to
become "ageless"! Too often government has been reluctant to actively pursue
receivables.
In making the change to collections management the key is to be fair but aggressive. As financial managers and cash managers we have to take a proactive position on receivables. We often pursue statutory receivables such as taxes but disregard lesser fees such as health fees, court fees, park leases, etc. In this manner we fail to take control of our assets. A totally passive position on receivables puts your revenues in danger.
The characteristics of the customer payments will determine your emphasis. If the payments are wholesale in nature (small volume and large dollar size such as industrial utility users) the emphasis should be on reducing float. If the collections are retail (large volume and small dollars such as taxes and citizen utility bills) the emphasis must be on processing costs. A collection study can help determine the emphasis.
Often by centralizing collection authority the collection process can be handled more economically for small fees. Coordinating collections between departments can improve collections in each. Centralized collections operations can better utilize staff resources by consolidating collections efforts and minimizing costs and duplication. A centralized database of receivables may also allow you to withhold services until the receivables are paid.
| Service | Unit | Unit Charge | Estimated Volume |
| Account Maintenance | Per month | ||
| Daily Balance Reporting | Per month | ||
| Zero Balanced Accounts | |||
| Master Account | Per month | ||
| Subsidiary Accounts | Per month | ||
| Credits Posted | Per transaction | ||
| Debits Posted | Per transaction | ||
| Encoding charge | Per transaction | ||
| ACH Processing | Per transaction | ||
| Origination of file | Per tape | ||
| ACH deletions | Per transaction | ||
| ACH entries | Per transaction | ||
| Returned checks | Per transaction | ||
| Controlled Disbursement | Per account/per month | ||
| Reconciliation | Per month | ||
| Sort list tape | Per transaction | ||
| Sort and list | Per transaction | ||
| Items Deposited | |||
| Deposits | Per transaction | ||
| Commercial deposits | Per transaction | ||
| Group I items | Per transaction | ||
| Group II items | Per transaction | ||
| Group III items | Per transaction | ||
| Group IV items | Per transaction | ||
| Stop payments | Per transaction | ||
| Wire Transfers | |||
| Incoming | Per transaction | ||
| Outgoing | Per transaction | ||
| Lockbox | Per month | ||
| Cutbacks | Per transaction | ||
| Special handling | Per transaction | ||
| Investment Safekeeping | |||
| Safekeepg interest/credit | Per transaction | ||
| Safekeepg receipt deposit | Per transaction | ||
| Safekeeping outgoing | Per transaction | ||
| Securities DVP FRB | Per transaction | ||
| Securities DVP NY | Per transaction | ||
| Check Printing | Per transaction | ||
| Extra Statements | Per transaction | ||
| Research | Per transaction | ||
| Bank Bags |
Security internal to the city is often overlooked. A review of all cash handling should be made to insure that both the cash and the staff handling it are secure. For example, are drop safes used in remote locations? Do the departments have police take funds to the city hall or bank or is an employee transporting it?
Armored cars are relatively inexpensive and often can be incorporated into the banking services contract. The bank will allow the city to piggy-back on the contract as long as the city makes a separate contract for liability purposes.
In addition to internal security of cash, checks and staff, the funds and assets must be protected as they are transported to the bank/depository. Deposits should always be made by armored car or armed personnel because the schedule is easily determined for these deposits. Lockboxes also protect funds by keeping them in a secured banking environment.
Once funds are deposited, they are secured fully only if they are collateralized. Several states use collateral pools or other arrangements to insure this level of collateral, but, if your city is responsible, it is critical to remember certain safeguards to perfect the collateral situation.
Collateralization of Deposits
The bank must agree to obtain and maintain collateral acceptable to the entity
sufficient to cover all anticipated and actual overnight balances, in time and
demand deposits, above the FDIC insured limit of $100,000. The collateral for
these deposits shall be held in a third party independent safekeeping
institution. The safekeeping bank must be independent of the bank or the bank's
same holding company. All collateral must be marked to market at least once a
month, which means the safekeeping bank will determine the accurate market
value of the collateral.
A margin of 102% of market value over the bank balances must be maintained at all times. If the city restricts to short treasury securities it may request only 100% value be maintained. The main banking services agreement MUST reference this tri-party agreement between the bank, the entity and the safekeeping bank which outlines the responsibilities of each. To assure that `you have your rights to this collateral the safekeeping bank must provide original, third party safekeeping receipts detailing the collateral which clearly shows, on its face, that the security is "PLEDGED TO...(the city)..." It is reasonable to allow substitutions of collateral if you have the right to approve the substitution before it is made. All substitutions of collateral are to be in writing and the city will make every effort to approve and process them in a timely manner.
The choice of what is reasonable collateral is dependent upon the controlling statutes and your entity's risk tolerance. A good rule of thumb is to make sure the bank only pledges securities for which the city can also assign market values. For example, limit collateral to securities listed in the Wall Street Journal. This curtails the bank somewhat but it is often difficult to get market values from the bank so it adds an extra level of security.
Since most public funds (non-pension funds) are short term in nature, and their highest priority must be safety, our discussion will focus on short-term, low risk investments. The words of Will Roger's should always be remembered when investing public funds: "I am more interested in the return of my principal than the return on my principal."
We will not discuss the most common types of securities in detail since that information is easily available. However, there are certain securities which will be reviewed.
Risk
Risk does not have to be the four-letter word. However, you can not invest
without risk. As public funds investors, it is our responsibility to identify
risks, limit those risks and use the manageable risks to provide reasonable
market yields on the portfolio. The process of cash activation discussed above
will measurably increase your portfolio's return for example since it will make
the maximum amount of funds available for investment.
In investing however you must assume additional risk to gain additional return. Therefore it is necessary to identify the types of risks and determine what level of risk you are willing to take in order to identify what your resulting reasonable level of return will be. It is a serious mistake to have unrealistic expectations of the risks or possible returns within your stated risk tolerance levels. By mismatching these two criteria, you make the investment manager stretch for unrealistic yields and thus incur more risk. Your investment policy will be a key ingredient to limiting risk and establishing realistic benchmark measurements.
Investment risk can be measured on three different levels: credit risk, market risk and liquidity risk. Credit risk involves the credit of counterparties or the credit risk of the individual securities. Since most public funds utilize the most secure government issues securities the credit risk is minimized. If you limit your investments to the following security types, little or no credit risk is involved.
These securities represent the most liquid market in the world. All these instruments are government guaranteed, but, this guarantee applies against principal loss only if the security is held to maturity! Since longer securities incur increased market risk, a portfolio of these securities are only secure only if they match your liability stream.
All other securities incur credit risk For example:
To limit credit risk therefore it is imperative to stay with the most common and actively traded securities.
Market risk involves the risk to your capital from moves in interest rates. It is possible that an asset will have to be sold at a price that is lower than the purchase, or book, price. For public funds, most market fluctuation risk can be reduced by matching securities to liabilities and buying only very short-term securities where volatility is minimal. Accurate reporting is also critical so that the investment officer knows the actual book value of a security (including accrued interest, amortization and accretion).
Perhaps the most critical type of risk for public funds is liquidity risk: the risk that funds will not be available when needed. To avoid such risks the portfolio must be kept short term and the liabilities should be matched.
Monitoring Performance and Risk
An excellent way for management to monitor the portfolio is to watch four key
points: the book value, the market value, the weighted average maturity (WAM)
and benchmark. The book and market value comparison will indicate whether the
portfolio is performing and can be liquidated without incurring a loss, if
necessary, for cash. Remember, the markets will always move and a negative
market value is not necessarily bad for the city if the WAM is short and the
securities are matched to liabilities. For example, a negative market/book
value is not inherently a problem if the weighted average maturity is 30 days,
however, it could be a problem if the WAM is 180 days. In the first case, the
securities will mature very soon. In the second, you may have lost liquidity
options and be forced to recognize some loss on the portfolio.
The investment policy should establish a weighted average maturity (WAM) which fits the use of the funds. For a normal city with a twelve month operating year the WAM should be six months or less to represent its average spending pattern. A benchmark should also be established by policy. Since public fund managers are not paid to outperform the market but to obtain market rates, the most effective and reasonable benchmark is the comparable treasury security. For example, for a portfolio with a six month weighted average maturity the benchmark should be the average yield on the six-month treasury bill yield over the same period. For example:
| Book Value at Beginning of Period | $ 5,001,565 | |
| Market Value at Beginning of Period | 5,020,755 | |
| Weighted Average Maturity at beginning | 100 Days | |
| Book Value at End of Period | 5,012,233 | |
| Market Value at End of Period | 5,011,666 | <567> |
| Weighted Average Maturity | 80 Days | |
| Benchmark Yield to Maturity over Period | 5.50% | |
| Yield to Maturity of Portfolio over Period | 5.00% |
In this portfolio, although there is a market value loss (book-market value) at the end of the period the WAM shows that the portfolio is being kept short and has indeed been shortened during the period. The comparison of these four factors allows the manager to quickly spot troublesome trends of losses or a portfolio that is dangerously long or unnecessarily volatile.
Building a Foundation for your Investment Program
Some of the factors upon which to build a solid investment program have been
mentioned above. The four cornerstones of your program will be:
The investment policy should set the standard for and control all the functions of investing. It is the most important policy in the cash management area. A sample policy is shown below with discussion points on various key components.
After you complete your policy, each policy should be approved by your governing body and reviewed annually by that body. In addition, it is a good idea to send a copy of the policy to each broker/dealer for their review so they know your specific requirements..
The policy must address safety, liquidity and then yield. It must also identify the entity's intent to restrict maturities to reasonable limits and diversify for safety. The policy might also address the capability of the investment managers. (Which should be considered in your strategy decisions.) The policy statement attempts to list these points clearly and set the tone for the entire policy. The policy statement can also state quite clearly the intent of the entity to either pursue an active or passive investment position. Most entity's, using in-house staff and resources, should state their intent to use a passive strategy.
And any new funds created by the City unless specifically exempted by the City Council and this policy.
The Scope of the policy might be restricted by types of funds. For example, a particular reserve fund might have its own separate policy because of the different requirements of such funds. If you chose to commingle funds for investment purposes you should state this intention in the policy so that the strategy covers all funds invested. A strategy statement can be incorporated into the Objectives and Strategy Section below.
Effective cash management is recognized as essential to good fiscal management. Cash management is defined as the process of managing monies in order to ensure maximum cash availability. The City shall maintain a comprehensive cash management program which includes collection of accounts receivable, prudent investment of its available cash, disbursement of payments in accordance with invoice terms and the management of banking services.
In a situation in which the local entity has additional statutory requirements or charter requirements affecting investment, those references should also be made in this section.
This section addresses the capability of staff. It is not necessary to list specific job requirements but anyone given the authority over investment transactions should be mentioned by title.
The Investment Officer shall develop and maintain written administrative procedures for the operation of the investment program which are consistent with this investment policy. Procedures will include reference to safekeeping, require and include PSA Master Repurchase Agreements, wire transfer agreements, banking services contracts, and other investment related activities.
The administrative procedures are very important and should be reviewed annually. The auditors, or an internal designated individual, might review the investment process for compliance with this policy and those procedures. The procedures should be approved by the City Manager or Finance Director depending on your staffing patterns.
The Investment Officer shall be responsible for all transaction undertaken and shall establish a system of controls to regulate the activities of subordinate officials and staff.
The Investment Officer shall designate a staff person as a liaison/deputy in the event circumstances require timely action and the Investment Officer is not available.
No officer or designee may engage in an investment transaction except as provided under the terms of this policy and the procedures established by the Investment Officer and approved by the City Manager.
The trading resolution is used to establish brokerage accounts and banking wire accounts, etc. The resolution is optional but makes the establishment of accounts more efficient. Any counterparty to a transaction will want to know with whom they are able to do business.
(In addition, your entity may want to establish a chain of approvals for each transaction. If so, the following may be used as optional language.) All actions taken under this resolution will require approval of at least one member of __________. Such approval may be obtained either in verbal or written form.
(OPTIONAL LANGUAGE) Wire transfer requests for investment clearing must be approved and signed by two of the four individuals designated to make investments.
The prudence of investment decisions should be based on the portfolio as a whole and not based upon the worth or history of a particular investment transaction. However, the statement of the prudent person standard is important to emphasize safety and the limitation of liability assures that no one making the investment can be held personally liable for market changes. This does not relive them of following the policy strictly.
Authorized investment must be listed along with maximum maturities for each type. The whole spectrum of allowable investments by your statutes is not necessary. The choice will be very dependent on your entity's risk requirements and tolerance. Most small entities using a buy and hold strategy will keep maximum maturities below two years and very conservative entities may restrict their purchases to one year maturities. The overall weighted average maturity (WAM) of the portfolio is dependent on the needs for the portfolio. For example, if the entity is investing operational funds from an annual budget then the WAM should probably be not longer than half of that term or 180 days. Give maturities and WAM careful consideration.
A. Obligations of the United States Government, its agencies and instrumentalities, and government sponsoring enterprises, not to exceed two years to stated maturity;
(OPTIONAL LANGUAGE) excluding collateralized mortgage obligations (CMOs),
B. Fully insured or collateralized certificates of deposit from a bank domiciled in the State and under the terms of a written depository agreement with that bank, not to exceed one year to the stated maturity;
CDs are extremely illiquid. You may want to add that CDs can only be from banks within your entity or other restrictions, dependent on political considerations.
C. Bankers acceptances as defined by your law not to exceed 180 days to stated maturity;
BAs are money market instruments that smaller entities may not want to utilize. They are not very liquid and not always available on the market. Though they are suitable investment and high quality with triple credit guarantees, smaller entities may have difficulty explaining the concept and the need for them to governing boards.
D. Commercial paper rated A-1/P-1 or the equivalent by at least two nationally recognized rating agencies not to exceed 180 days to stated maturity;
CP is an unsecured promissory note of a corporation. For that reason, many entities chose not to use CP although it is very liquid and often offers additional yield.
E. Repurchase agreements and reverse repurchase agreements not to exceed 180 days to stated maturity, provided an executed PSA Master Repurchase Agreement is on file with the City and the counterparty bank or primary dealer;
Most repo will be done on an overnight basis, but, occasionally term repo extending several weeks or months may be efficient for investment purposes.
F. No-load, SEC registered money market funds, rated AAA, each approved specifically before use by the City Council. No more than XX% of the entity's monthly average balance may be invested in money market funds;
Money market funds are a specific designation of the SEC. Any use of funds must be carefully researched and full approval of the governing board should be obtained. Money funds are allowed under SEC requirements to use investments not usually authorized by governing law (for example corporate securities) therefore a careful examination and evaluation is necessary.
G. Local Government Investment Pools as defined by State law; and,
Investment pools can be used for effective investment of liquid funds. The policy can simply state that any authorized fund can be used or specify a pool by name. The pool will usually require a resolution from the governing body before an investment can be made.
H. No-load, mutual fund registered with the SEC, rated AAA by at least one nationally recognized rating agency, investing exclusively in this policy's authorized investments, and having a weighted average maturity of not more than two (2) years. No more than XX% (10%) of the entity's monthly average balance may be invested in these funds.
The use of mutual funds requires considerable time, attention and care by public officials. The fluctuating net asset value of the shares in such a fund will require active maintenance and monitoring by the staff and particular attention must be given on the initial investment as to conformance to requirements. Small entities will probably not want to include this item in their authorized investments.
If additional types of securities are approved for investment by public funds by state statute, they will not be eligible for investment by the City until this policy has been amended and the amended version approved by the City Council.
Some entities will decide to open this requirement to the use of regional brokers. The suggestion is to use only primaries because of the existing capital requirements and oversight/regulation that exists on primary dealers. If an entity decides to use regional brokers, they must have additional information on hand on that broker including financials, trading volume on the securities the entity may buy, names and contacts for back-up coverage and supervisors. The entity may choose to restrict regional brokers to those only with offices in the state.
The City shall maintain a list of financial institutions which are authorized to provide investment services. Banks shall continuously provide their most recent "Consolidated Report of Condition" (call report). At a minimum the City shall conduct an annual evaluation of each bank's creditworthiness to determine whether it should be on the "Qualified Institution" listing.
Checking bank credit can be independently completed through the use of a rating service such as Sheshunoff or Prudent Man. Of course, this is most important for your banking services institution.
Securities broker/dealers not affiliated with a bank, shall be required to be classified as reporting dealers affiliated with the New York Federal Reserve as primary dealers, and meet certain other criteria as determined by the Investment Officer. A list of no more than five (5) authorized primary dealers will be established and maintained. The following criteria must be met by those firms on the list:
If regional brokers are used, the questionnaire should be expanded for additional information on the firm and the broker involved. A copy of the questionnaire can be attached as an appendix to the policy.
Every dealer with whom the City transacts business will be provided a copy of this Investment Policy to assure that they are familiar with the goals and objectives of the investment program.
Brokers are required to "know their clients". By providing a copy of the entity's investment policy the broker can fulfill this requirements and then knows your limits.
As investments are made, the Investment Officer shall rotate from the authorized bidder's list for bids/offers. An attempt will be made to alternate to all names on the list.
| U.S. Treasuries and securities with the US Govt's guarantee | 100% |
| U.S. Govt agencies and instrumentalities | not to exceed 50% |
| Fully insured or collateralized CDs | not to exceed 30% |
| Banker's acceptances | not to exceed 15% |
| Commercial paper | not to exceed 25% |
| Maximum per CP issuer | not to exceed 10% |
| Repurchase agreements | 100% |
| Money Market funds | ??? |
| Operating Funds | not to exceed 50% |
| Bond funds | 50% |
| Local Government Investment Pools | ??? |
| Liquidity Pools | 100% |
| Net Asset Value (Longer duration) Pools | not to exceed 30% |
| Maximum percent ownership of pool | not to exceed 20% |
| Mutual Funds | not to exceed 10% |
The Investment Officer shall be required to diversify maturities. The Investment Officer, to the extent possible, will attempt to match investments with anticipated cash flow requirements. Matching maturities with cash flow dates will reduce the need to sell securities prior to maturity, thus reducing market risk. Unless matched to a specific requirements, the Investment Officer may not invest more than 20% of the portfolio for a period greater than one (1) year. Unless matched to a specific requirements, the Investment Officer may not invest any portion of the portfolio for a period greater then two (2) years.
(OPTIONAL LANGUAGE)
All safekeeping arrangements shall be designated by the Investment Officer and an agreement of the terms executed in writing. The third party custodian shall be required to issue original safekeeping receipts to the City listing each specific security, rate, description, maturity, and cusip number. Each safekeeping receipt will be clearly marked that the security is held for the City or pledged to the City.
All securities pledged to the City for certificates of deposit or demand deposits shall be held by an independent third party bank. The safekeeping bank may not be within the same holding company as the bank from with the securities are pledged.
(OPTIONAL LANGUAGE) The Investment Officer must approve release and/or substitution of collateral before such action is taken.
In order to anticipate market changes and provide a level of additional security for all funds, the collateralization level required will be 102% of the market value of the principal and accrued interest. Collateral will be of the following type securities only:
The margin of 102% allows to the entity to prepare for any market price change during the term of the repo or CD. Both the Master repo agreement and the depository agreement for purchase of CDs should stipulate who and how often the collateral should be priced. The City may want to restrict collateral to securities which they price themselves from the financial press.
It is important that reporting be done on a frequent basis to identify problems or changes. The annual report should encompass activity through the entire year.
(OPTIONAL LANGUAGE) The monthly report will summarize investment activity and include, at a minimum, the following information:
The depository provides the safekeeping for the entity's securities and therefore comes within the policy. In addition, the banks from which you buy CDs are depositories and therefore the entity must have a depository agreement in place before purchase.
| City Secretary/Clerk | Date |
Collateral is also addressed above and is a prime consideration for the investor. Collateral should be used for bank depository pledges and for repurchase agreement collateral. In both cases, the governing agreement must be in writing and clearly designate rights and responsibilities of both parties.
Contracts play an important role in investments. Several contracts will be required to assure that all your safeguards are in place. Naturally, a banking services contract, as discussed above, is required. This contract forms the foundation for your cash management banking program.
A wire transfer agreement is necessary with authorized individuals clearly designated. If repurchase agreements are being used by the city (with a primary dealer or a bank), an executed master repurchase agreement must be in place.
Rather than trying to write a master repurchase agreement or use a bank generated agreement (which is often one-sided) it is recommended that you use the Public Securities Association (PSA) Master Agreement to cover your transactions. This agreement clearly equalizes the rights and responsibilities of each party which is critical in repurchase agreements (since you will take the role of both buyer and seller during the transaction).
Although not a contract, the city should have clear guidelines for the staff's use of brokers and requirements for broker/dealer counterparties. This is important so that you know and can monitor the firms which with you do business. Certain basic requirements should be met by the broker such as:
Competitive Bidding is required. Three bids (a sale) or offers (a purchase) should be received from your broker or bank on any securities transaction. Markets often move quickly, so the three bids/offers must be expeditiously gathered and executed. More than three bids/offers is unnecessary and often counterproductive.
NAME OF FIRM:
(Parent Company also, if applicable)
ADDRESS:
(Phone)
(800) ______ - __________
ACCOUNT REPRESENTATIVE:
Title:
BACKUP REPRESENTATIVE:
Title:
DO YOU HAVE A STATE OFFICE OF THE FIRM FOR BROKERAGE OR OTHER SERVICES?
ADDRESS OF OFFICE
NATURE OF OFFICE
HAS THE REPRESENTATIVE BEEN GIVEN CLEARANCE BY THE FIRM TO BE THE SOLE REPRESENTATIVE FOR THIS ACCOUNT?
BY WHOM?
HOW LONG HAS THE DIRECT REPRESENTATIVE BEEN AN INSTITUTIONAL GOVERNMENTAL SECURITIES BROKER AT THE FIRM?
HOW LONG HAS THE REPRESENTATIVE BEEN AN INSTITUTIONAL FIXED INCOME BROKER AT THIS AND OTHER FIRMS?
DOES THE FIRM HAVE PRIMARY DEALER STATUS WITH THE FEDERAL RESERVE?
HOW LONG HAS THE FIRM HAD PRIMARY DEALER STATUS?
IS THE FIRM AND THE ACCOUNT REPRESENTATIVE REGISTERED WITH OUR STATE SECURITIES COMMISSION?
SINCE?
DO WOMEN OR MINORITIES HAVE SIGNIFICANT OWNERSHIP OR SENIOR MANAGEMENT POSITIONS WITHIN THE FIRM?
This page is to be completed by any firm which does not currently hold primary dealer status. IN WHICH MARKET SECTORS DOES THE LOCAL FIRM/DESK SPECIALIZE, IF ANY?
PLEASE IDENTIFY YOUR MOST DIRECTLY COMPARABLE PUBLIC SECTOR CLIENTS.
HOW LONG HAS YOUR FIRM BEEN IN BUSINESS?
IS THIS A SUBSIDIARY OF ANOTHER FIRM? If yes, which firm?
HOW LONG HAVE THE TWO FIRMS BEEN ASSOCIATED?
WHAT WAS THE FIRM'S TOTAL VOLUME IN U.S. TREASURIES AND AGENCIES FOR THE LAST FISCAL YEAR?
FIRMWIDE: $
THIS OFFICE $
DO YOU HAVE FULL SIPC INSURANCE COVERAGE?
PLEASE PROVIDE INFORMATION ON A SEPARATE SHEET REGARDING ADDITIONAL COVERAGE FOR YOUR CUSTOMERS IN CASE OF DEFAULT OR FAILS.
IS YOUR FIRM AN INVENTORY DEALER? DO YOU TAKE A POSITION IN SECURITIES WHICH YOU SELL OR BUY?
DOES YOUR FIRM AGREE TO COMPLY WITH THE SEC NET CAPITAL GUIDELINES ON A CONTINUOUS BASIS?
HOW MUCH EXCESS CAPITAL DO YOU MAINTAIN?
THROUGH WHICH FIRM DO YOU CLEAR?
DO YOU CLEAR ON A FULLY DISCLOSED BASIS, I.E. WILL THE CLEARING FIRM BE ACTING
AS PRINCIPAL ON THE TRANSACTION?
PLEASE ATTACH A SEPARATE SHEET WITH YOUR FULL DELIVERY INSTRUCTIONS.
The public funds portfolio should always be measured against a comparable maturity treasury security and an entity should never push its internal investment staff to balance the budget with investment earnings. The portfolio should provide solid investment returns and can provide good incremental earnings.. The City Manager and Council are responsible to assure that this attitude is maintained throughout the organization.
A discussion of the yield curve, its patterns, and its impact on specific investment securities and portfolios is too lengthy for this article. Management should simply remember that although yield is important to the city, the first priority of public funds is safety. Research and remember the limitations of your policy and your staff (which wears many hats) and base your expectations accordingly. The monitoring of yield-to-maturity on the portfolio along with the weighted average maturity, and book/market values should give the manager all the information that is needed on an ongoing basis. If a problem is detected (too long a WAM, significant losses in market value, or unrealistic yields being reported off the portfolio which indicates high risk) portfolio details should be examined.
Investment accounting must insure that the book and market values of the securities are accurate and recognize all the factors which influence these values. There are three terms which should be understood and incorporated into that accounting: accretion, amortization and accrued interest. Most fixed income and money market securities (treasuries and agencies) pay interest semi-annually. They accrue interest throughout that semi-annual period. When you buy that security you must buy the accrued interest and when you sell you must sell it so it is important to know what the accrued amount is at all times. The accrued interest is increasing every day.
If you buy a security above the price of 100 (par), you have bought it at a "premium". This premium amount must be "amortized" back to par over the life of the investment (to maturity). The amortization, is an expense charged against your coupon earnings to determine your actual yield. The amortization amount is calculated daily to determine the updated book value of the security.
Finally, if you buy a security below the price of 100 (par), you have bought it at a "discount". All treasury bills, for example, are sold at a discount. Over the life of the security the daily accretion represents income and must be added to the book value of the security daily to reflect an accurate value.
These accounting calculations are important for management to understand because they affect the accuracy of the management reports. Provision should be made so that adequate systems are available to your accounting staff to assure that all these calculations on an are timely and accurate. The complexity of the accounting function is one factor which has lead public investors to use local government investment pools, money market funds and investment advisors (external money managers).
A detailed look at various securities requires more space than is available in this article, however, we will look briefly at certain security types for clarification. These are now used by many small governmental entities which may not understand their ramifications.
There are two types of commingled funds: (1) a constant dollar type and (2) a fluctuating net asset value (NAV) type. Most governmental entities focus is on safety and liquidity so they would want to stay in short-term and stable commingled funds and not chose longer funds where there is a possibility of principal loss. Regardless which type you chose it is critical that you understand the two different types because they are for different types of money and require different types of monitoring from your staff.
The distinction between the two types of funds centers on (1) the type of securities used, (2) the average maturity of securities used, and (3) the accounting of unrealized gains and losses in the portfolio. Neither one is a CD!!
The constant dollar funds and LGIPs are restricted to short-term securities and short WAMs. Since they are made up of short term securities that are not very volatile in the market, the value of the shares does not fluctuate significantly. This type portfolio is required to maintain a $1 net asset value (or price per share) - i.e. the term constant dollar. These funds reflect only actual and realized earnings (profits and losses) as they occur and those changes are in the rate paid to the participant. A "money market mutual fund" is a defined SEC term which indicates a short-term fund with an maximum average WAM of 90 days. All "money markets" are constant dollar. These constant dollar funds or LGIPs are stable and the rate will not change quickly. These are excellent investments for money with high liquidity needs and those entities concentrating on safety.
The fluctuating net asset value LGIPs and funds are made up of longer securities which are prone to market volatility. Since this volatility can change the value of the underlying securities radically and quickly, the share owner must be aware of this value change. For this type, the value of the share recognizes unrealized market value and, as a result, the price per share can fluctuate - i.e. the term fluctuating net asset value. This results in a volatile price change on the share. There is absolutely no guarantee that the fund will ever return any funds to the investor. A "mutual fund" always has a fluctuating net asset value.
Both of these instruments are valid investments but for very different types of money. A city which has limited funds and must use those funds on an operating basis (i.e. needs liquidity) would only want to use a constant dollar fund or LGIP since it guarantees liquidity and matches its short term funds use. The rate will not be spectacular but will parallel short term market rates.
Dollars that are not needed for a long period, and can absorb more risk, could utilize the fluctuating net asset value. The fluctuating NAV fund or pool should however be traded like a security. Several months prior to the planned use of the money, the money should be taken out of the fluctuating fund at a high or reasonable price level that meets the investor's expectations of returns and then placed in the stable constant dollar instrument to assure that funds are available when needed. If not, there is a chance that the net asset value is low or below your expectations and the government could actually lose principal.
Fluctuating Net Asset Value (recognizing unrealized market value gains and losses)
Starting market value of the Lonesome Dove Fund is $ 10,000,000 and it has 100,000 shares and a share is worth $100 each
Entity A puts $1,000,000 in the Lonesome Dove Fund and buys shares at $100. There are now 110,000 shares owned of the fund.
If market value of the fund increases by $2,000,000 the share is now worth $109 (or $12,000,000/110,000 shares).
If market value of the fund decreases by $2,000,000 the share is now worth only $72 (or $8,000,000/110,000 shares).
Constant Dollar (not recognizing unrealized market value gains and losses)
Starting out the Cowpaddy Pool has $ 10,000,000 and it has 100,000 shares a share is $1
Entity A puts in $1,000,000 in the Cowpaddy Pool with 10 other investors
The Pool has yield of 3.5% (the yield on the securities without unrealized gain/loss). Therefore, Entity A earns 3.5 ($95) that day.
If market value in the portfolio increased to $12mm but no losses or gains were taken, Entity A still earns 3.5 or $95.
If market value decreased to $9mm but no losses or gains were taken, Entity A still earns 3.5% or $95.
Regardless of the type commingled investment vehicle you use, the city must be fully informed about the instrument. Information can be gained through three types of disclosure which must be available to the investor: (1) the offering circular (or prospectus) which outlines the general characteristics of the fund or pool, (2) individual transaction confirmations for every transaction made, and (3) full monthly reporting which profiles the fund or pool at that point in time. These should be reviewed and understood thoroughly.
The growth of LGIPs and funds has been dramatic and even the losses in the Orange County LGIP in 1994 has not seriously diminished their growth because of the convenience and general safety. For the small institutional investors the LGIPs and funds are beneficial for a number of reasons.
Most importantly, the city must determine that the pool or fund meets its own parameters and requirements. For example, does the portfolio reflect your own portfolio requirements and risk tolerances, does the WAM match your requirements and those of your funds, and are you comfortable with the securities it uses (for example SEC registered "money market funds" can use corporates which most governments can not so the prospectus must be checked). It is up to you to identify the number, type and size of the participant base, the redemption requirements, the costs and fees, and the security measures.
A repurchase agreement, or "repo", is a simultaneous buy-sell agreement. It allows for the very short term (including overnight) investment of odd amounts of money at attractive rates. For example, a city has $1 million to invest overnight as a sweep of its accounts. They check three repo rates from authorized dealers and choose the highest rate. By agreeing to do the repo at a set rate, the city is agreeing to "buy" the collateral today and "sell" it back tomorrow for the principal and agreed upon interest. The city will take delivery of the collateral through its designated depository.
There are a few important factors to remember about repurchase agreements to assure their safe usage. (1) It must always be executed under a Master Repo Agreement - preferably that of the Public Securities Association (the PSA Agreement). The agreement outlines all the rights and responsibilities of both parties. The PSA agreement is excellent because it equalizes these rights. Remember, today you are the buyer and tomorrow the seller! (2) The city must always take delivery of the collateral through DVP delivery to its designated depository. (3) If possible, allow New York law to govern the agreement (not the venue). New York has existing case law governing bankruptcies which will facilitate possible litigation. (4) The city should impose reasonable margin requirements. The collateral provided for the transaction will represent at least 100% market value of the principal invested. Cities will normally require 100-102%. The additional margin (or "haircut") is to protect against market price fluctuations. If this is an overnight transaction the fluctuations will be minimal and therefore 100-102% is acceptable. If you are accepting more volatile or long term securities, you may want to require 105%. (5) Always require collateral which you understand and can price yourself. It may be reasonable to restrict collateral to treasuries and agencies with maximum maturities of ten years. By restricting the collateral you restrict your yield somewhat but fulfill the primary objective of safety.
As conditions change and home-owners refinance or pay-off mortgages the funds flow more rapidly. For example, as rates decline and more people refinance homes, funds back through to the investor will increase. These funds return when the investor has to reinvest his funds at the lower current rates. This is "pre-payment risk".
To generate higher earning potential, the market restructured the traditional mortgage backed and created CMOs, or collateralized mortgage obligations. These took the same pool of mortgages but sliced the mortgage pool up differently. There are any number of varieties of tranches for the investor and their analysis is difficult and time consuming. Some of the slices, or"tranches", were structured like the old MBSs but many carried higher risks and potential rewards. The pre-payment risk had to be absorbed somewhere in the pie! These riskier tranches were more volatile and lost value much more quickly when rates fell.
Mortgage-backed products and CMOs can be effective and safe investments, however, only if the investor fully understands the structure and the implications of market volatility on the security. Very few municipalities have the expertise, analytical tools and market information to evaluate and manage these instruments. As a result, most municipalities should avoid their use. The risks involved from these securities, especially if they are used as a major component of a portfolio, can not be over-emphasized. Cities wishing to use the securities might be wise to use a knowledgeable external manager.
It is unwise to simply state a policy that precludes "derivatives" or "structured notes" because there are safe and secure types of derivatives. Any callable security could be classified a derivative. Many short-term callable notes, such as a two year note with a one-year call spread significantly above treasuries in yield, add considerable value without risk to the municipal portfolio. And, short floating rate securities, such as a standard three-month floating Farm Credit note, can be a wise investment when rates are anticipated to rise because it "floats" up with rates. The primary caution for investors is to fully understand the underlying structure and how it can react in various interest rate scenarios. Without the experience and analytical tools available for 'stress-testing' your portfolio and securities, it is incumbent on public fund investors to stay with safe securities.
For larger entities or those with discretionary core funds, the strategy decision may include more active management of the portfolio. This probably means that the portfolio will be longer in weighted maturity to take advantage of normally higher rates. An active management style will involve trading securities when they are at a profit position and moving around the yield curve to take advantage of curve aberrations. This should only be used by entities which have the staff to trade safely and effectively and the size portfolio to recognize the difference. A more active management style requires that the city dedicate the training, time and technology to assure that the portfolio is safely managed. This strategy involves considerably more risk. There is a tendency for the untrained investor to "churn" the portfolio (trade for no acceptable reason).
If you adopt an active style all layers of the staff, including supervisors and management, should be very aware of the portfolio and monitor reporting closely. Many public and private entities which want to adopt a more active style to capture the definite yield potential for their funds utilize professional external investment advisors. A registered investment advisor should be able to increase the yield on the portfolio net of her fees because of market knowledge and access.
Both types of strategies should address, in writing, certain parameters which will guide the investment manager. A strategy statement would include such items as suitability of investments, marketability of the securities, yield requirements and expectations, ability of entity staff to invest, and diversification.
Regardless of the type of management style used the majority of an operating portfolio, which will be used for meeting operating expenses, will be matched to anticipated liabilities in a ladder type structure.
In the area of disbursement the entity can use wires and ACH effectively. Large payments in particular allow the entity to benefit. For example, by wiring debt service funds on the day of payment the entity has use of the funds as long as possible. The wire instructions, settled in advance, assure a timely payment to the paying agent.
In summary, public funds and public fund investors are not expected, nor wise, to be on the cutting edge and should not be expected to outperform investment professionals. They do need, however, to be just one step back from that edge. They need to investigate and utilize the systems and services available today. The public funds investor must take advantage of tested technology and techniques in cash management. The technology, techniques, and systems available to the public manager in banking, billing, receivables, security, and investment management can generate significant efficiencies and earnings for any city. The key must be to build a strong foundation upon which to build your cash management systems and an understanding of the risks and returns inherent in those opportunities. A viable cash management program will always return to the basic objectives of safety, liquidity and yield which must govern the management of public funds!
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 who can spend extended time working solely on the investment portfolio. 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 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" 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. The larger entities often do have access to 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. We simply have to learn the 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 which 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 should normally limit the smaller entity to investment options within a one year or eighteen 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 becomes the first step in building a portfolio. A cash flow analysis will determine the amount of funds necessary in the general time frame. 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.
With the downsizing in many large brokerage firms, a small entity does not always receive the attention given to larger accounts. Small regional brokerage firms usually do not trade in large block size and do not purchase securities on a regular basis so coverage may be limited. This can be a detriment, but, need not be. Small entities can receive the same level of quality coverage from primary and regional brokers if they take the time to learn about the products they are allowed to buy and build a relationship with several brokers who cover small accounts. Therefore, it is imperative that smaller entities use at least three reputable broker/dealers in insure that they receive balanced and accurate market bids (sale price) and offers (purchase price). Smaller entities, like any entity, should set compliance requirements for brokers, check references with your peers, take three bids/ offers, and always get full information.
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.
This article will not define each security or look at each of its technical aspects. That information is readily available and should be read and understood before you purchase any of the choices. Instead we will focus on some of the major factors that affect that alternative's value to a small portfolio.
Many larger investors actually use Bills as a cash equivalent because of this liquidity. This type trading causes what we call an active "secondary market" for the Bills where you can always find a buyer. (Just remember it may not be at your price.)
The short end of a normally shaped treasury yield curve is steeply upward sloping. Since Bills constitute the short end of the treasury yield curve they have the natural effect of "rolling down the curve" which is very beneficial to the small investor. (See next section on investment strategies.)
The ability to buy directly from the Treasury is often touted as a benefit of Bills. Although you can buy from the Treasury the auction process is cumbersome. Because of the size and efficiency of this market, it is just as effective - and easier - to buy from a broker after three offers are received.
Spreads will vary considerably given market conditions but a general rule of thumb is that there should be a spread over the comparable Bill. Watch for legitimate spread claims. In an inverted curve (short maturities are the highest yields) a salesman will often say "these offer a great spread of 22+ to the Bill". What he doesn't say is that the shorter bills or cash are even a better buy. You have to check where all the relative value is on the curve not just your maturity range!
If your funds are "swept" overnight by your bank they are probably using repo or a money fund as the investment vehicle. Moving large pieces of collateral makes the transaction more cost efficient for larger investors. The collateral transfer costs may be cost prohibitive for small entities. The smaller investor has access to the repo market however through two new innovations. Many primary broker/dealer firms offer tri-party repo. In this arrangement the collateral is held by a large money center, independent, third-party bank. It has the same guarantee as regular repo but avoids the collateral transfer costs. In addition, some firms have small user repo programs using a modified tri-party agreement. The small entity calls in on a PC and invests small amounts of money for one day or several days at a set rate. The firm combines all these small amounts and enters the repo market as a large player but assigns collateral individually.
There are no real disadvantages to repo in supplementing your marketable securities, but, you must be careful to have an Master Agreement in place and have your collateral priced.
A crucial point with pools and funds is to understand the two types of funds available and how to use them for investments. The first type, the constant dollar funds, are designed for liquidity. In this type the net asset value (NAV) is kept at a constant $1 value. Unrecognized gains and losses are not calculated into the NAV. As a result, the value is quoted as yield and the interest accumulates. These are no
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