INVESTING SCHOOL FUNDS

Public Funds Investment Act Workshop

Linda T. PattersonPatterson & Associates

linda@patterson.net

What is public investing?

Managing risk

Putting money to work. Creating a performing asset Building a portfolio to serve the entity

Utilizing markets and products for entity benefit

Adding yield but not risk to the portfolio

Assuring cash efficiency and security including banking arrangements

Public Investor as Fiduciary

Special fiduciary duties for public funds:

market and internal entity knowledge to understand risk to be conservative to be pro-active and curious effective communication skills

What is PFIA Designed to Do? Provide guidelines for safety

Apply to all entities

Allow entities to set their own parameters

Limit investments to high credit quality for safety

Provide for flexibility (maturity)

Provide for control on extension risk (WAM)

The Standard of Care

Prudent Person Rule Investment shall be made with judgment and care, under prevailing

conditions, that a person of prudence, discretion, and intelligence would exercise in the management of the person’s own affairs, not for speculation but for investment considering the probable safety and probable income to be derived.

Essentially I am more concerned with the return of my money than the return on my money

A key point is “circumstances then prevailing” because conditions change Market changes Internal district changes

PFIA

Public Funds Investment Act Texas Government Code 2256

Public Funds Collateral Act Texas Government Code 2257

Their development reflects changing circumstances and changing needs

Change is continuous in the investment arena

6

PFIA Anatomy

1987 PFIA passed splitting banking and investments Simple restrictions for safety

1989 PFCA passed setting collateral rules Pools were created

1993 CMOs added specifically as rates were falling

1995 Orange County CA declares bankruptcy

7

1995 Reaction to Orange County

Prohibition added for certain MBS/CMOs Reverse repurchase agreements restricted by term and tied to the

reverse term (leverage)

Designation of investment officers added Training for local and state investment officers required Broker certification required

“imprudent investments” original language

Added controls maximum maturities and WAM

Written quarterly reports required

8

1995 – More Controls

Prior authorized investments not required to be liquidated

Loss of required rating requires prudent liquidation

Pools require rating of AAA or equivalent

State purchase and delivery of securities regulations

Municipalities with utilities authorized to hedge Money market mutual funds (and funds) added

9

1997 Continuing Concerns

Investment officer training extended to 10 hours within 12 months and every two years

Delivery versus payment required in policy and action

Officer ethics disclosure required

Broker list creation and approval required

10

PFIA

Banks are healthy and looking for fees

1999 GICs and hedging expanded State of Israel bonds authorized

2001 Letters of credit authorized as PFCA collateral

2003 CDARS specifically approved

2005 Hedging expanded

11

PFIA

2009 banks crash on credit concerns Hedging expands with Eagle Ford and Barnett Shale

2011 brokers are hungry and look for options FICA and brokered CDs added

2013 Only year not to see PFIA change PFCA changes to require entity to request monthly reports

12

2015 Changes

Investment Officer Training Changes Only

Initial 10 hours of training within 12 months of taking the position

Continuing training for schools and cities changed Eight (8) hours every two years after initial training Period starts on first day of fiscal year

Lessons from History

Not all the changes made affect you or should Unique situations must be judged as such

Not all the changes are necessarily good Often result of reach for yield or outside influence

The devil is in the details You have to understand why the change occurred

14

PFIA Requirement - Policy

• Write a Policy: (2256.005)

• Emphasize safety and liquidity• Address diversification, yield, maturity & capability• List authorized investments• Include procedure to monitor credit rating changes• Set a maximum maturity and WAM• State how market prices are monitored• Require delivery versus payment (DVP)• Review and adopt policy annually

PFIA Requirement - Strategy Board must review and adopt the strategy annually

Approving resolution should reference policy and strategy adoption

A strategy must be written Include in policy to tie the two

Set strategy by portfolio Or one commingled portfolio

Strategy should describe how you will achieve: Objective of investments Suitability of instruments Safety Liquidity Diversification Yield

PFIA Requirement - Officers Board must designate investment officer(s)

Board resolution required Name individuals and authorizations Effective until rescinded or officer is terminated Option on choosing officers (no necessary set position) Board may designated a management firm as officer

The Officer shall be responsible for the investment of its funds consistent with the adopted investment policy,

The Officer may deposit, withdraw, transfer, establish bank accounts for investment purposes, and manage the funds of the district.

PFIA Requirement - Training

Board must provide for Officer training

Board (or Investment Committee) must approve training sources Approval is not required annually

Required training Initial training: required within 12 months of appointment or position Continuing training: required every two succeeding fiscal years Cities and school districts require 8 hours each 2 fiscal years Two year is set on your fiscal year

Required training is for (a) treasurer, (b) CFO (if Treasurer is not CFO), and (c) all designated investment officers

PFIA Requirement - Disclosure

Investment Officers must disclose personal/business relationships

Refers to personal business relationships

Full disclosure to the Superintendent will protect you

Requires disclosure to Texas Ethics Commission IF: the investment officer owns 10 percent or more of the voting stock or shares of the business

organization or owns $5,000 or more of the fair market value of the business organization; funds received by the investment officer from the business organization exceed 10 percent

of the investment officer’s gross income for the previous year; or the investment officer has acquired from the business organization during the previous year

investments with a book value of $2,500 or more for the personal account of the investment officer.

19

PFIA Requirement - Certification Not a guarantee

Policy certification All firms wishing to sell a transaction must provide certificate

Includes broker/dealers, pools, and banks It is not a guarantee

Certification “in a form acceptable to the investing entity and the firm substantially to the effect that the firm has:

1. received and reviewed the investment policy of the district; and2. acknowledged that the firm has implemented reasonable procedures and controls in an

effort to preclude investment transactions conducted between the district and the firm not authorized by the investment policy,

3. except to the extent that this authorization is dependent on an analysis of the makeup of the entity’s entire portfolio or requires an interpretation of subjective investment standards.

Why firms resist the certification process Responsibility must be shared with the district Firms not willing to take on full responsibility – it isn’t theirs

PFIA Requirement

Broker/Dealers List Annual review of authorized broker/dealer list by Board Does not include banks or pools Not required if broker/dealers not used

Two Audits Compliance audit

Annually obtain or complete an annual management audit Assuring compliance with the Policy and the PFIA

Audit by independent auditor may be required if invested in more than CDs and pools

21

PFIA Requirement - Reporting

Reporting Must be prepared jointly by investment officers Must be signed by each Investment officer Must be submitted to Board quarterly

On a timely basis

Must contain detail and summary information Must conform to PFIA report requirements Must state compliance with Policy and PFIA

PFIA Items

CDs may be bought orally

Prudence is based on the whole portfolio

Prudence to liquidate at loss of rating Does not constitute an authorized security with lower rating Policy must include procedure for monitoring credit rating and

possible liquidation

No need to liquidate if authorized at purchase Discuss and decide the reasonable action to take

Public Investment Objectives

Preservation of principal Preservation of capital

Liquidity Assuring that funds are available Covering known and unexpected expenses

Diversification Avoiding risk of over-concentration

Yield Making all the funds work

How do we achieve the objectives?

How do I achieve Safety?

Document all transactions Use competitive transactions Recognize changes in your and the markets’ situation Learn about the various securities/opportunities Use independent counter-parties Delivery versus Payment (DVP) Settlement Review and report regularly Establish controls and procedures Review contracts

establish equality review for practicality

Establish Collateral Independent safekeeping and reporting

Diversify

How do I achieve Liquidity?

Create and understand your cash flow

Invest to known liabilities Providing liquidity at appropriate time

Always have a small cash buffer for emergencies

Buy high quality securities High quality assures a secondary market

How do I achieve Diversification?

Create competition in every transaction Never rely on one institution or broker Do not allow a broker to do competitive bidding for you

Diversification by type of security Knowledge of the securities Use securities that make sense for the period

Diversification maturity Create a ladder to meet your liabilities

How do I achieve Yield?

Invest to your cash flow needs

Knowing your securities and use appropriate ones

Assure there is always competition

Use time and attention for the portfolio

Know your alternatives and compare them

Use the alternatives available

Commonalities

SAFETY LIQUIDITY DIVERSIFICATION YIELD

cash flow cash flow cash flow cash flow

information information information Information

controls controls controls

diversification diversification diversification diversification

documentation

contracts

competition competition competition

documentation

procedures procedures

credit quality credit quality

Change Market conditions change constantly

Know the “circumstances then prevailing” Always use competition The best weapon is information Do not single-source information Have a reasonable process for downgrades Ongoing disclosure to governing boards will help

Internal situations change Changes in tenured individuals Board proclivities for risk change New or different types of funds may change (bond $$) Weather events may influence need for liquidity

Legislation changes

Changing Rates

End of Month Rates - Full Yield Curve – Fed Funds to 30yr

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

3mo 6mo 1yr 2yr 5yr 10yr 30yr

Sep-15

Jun-15

Mar-15

Dec-14

Oct-14

Percent

Rates fall in a race to safe haven Treasuries

What is Changing? Why?

• What is driving the rates and markets currently?

• What factors will change outlooks?

Investment Process/Cycle

The process is a cycle

Cycle verifies that circumstances have not changed

Process applies to all types of investing

Process requires ongoing systematic review

Step 1: Cash Flow

Identifies when you need money to pay bills and when not

Protects your liquidity

Improves investment returns

Establishes parameters for policy guidelines Maximum maturity Maximum weighted average maturity Risk benchmark

Promotes safe maturity extensions

Defines your portfolio

Cash Flow Analysis Study of how cash moves through an entity

Identifies: Surplus periods Problem periods Extension opportunities

Provides basis for all decisions

Protects your liquidity

Improves investment returns

Establishes parameters for policy guidelines

Defines your portfolio

Cash Flow Time Horizons

Time horizons provide structure and decision basis

Defines the portions of your portfolio Helps set strategy for each time portion of the portfolio

Allows pro-active investments Provides comfort that necessary funds are available Allows some extension by recognizing future flows

Yield is not the end-game but an added benefit

Time Horizon for Debt Service

A $2mm debt payment is scheduled out 6 months

$400,000 is paid in each month to meet debt service

Staying liquid over the 6 months earns $14,000

Investing each successive month at rates shown earns $16,333

Horizon Yield

Overnite 2.0 %

1 month 2.1 %

2 months 2.2 %

3 months 2.3 %

4 months 2.4 %

5 months 2.5 %

Cash Flow Approaches

Both approaches have same goal Present viable information for decision-making Develop parameters for portfolio structure Limit liquidity risk

Traditional approach details Define all variables Build on extensive historical data Extensive analytics for forecasting

Expense Orientation simplifies Limit the elements being analyzed Designed to get going faster

The 80-20 Rule

Regardless of approach Capturing every detail can be overwhelming in detail Can be difficult to maintain

80% of expenses come from 20% of expense categories Payroll and fringes probably account for 80%

80% of revenues come from 20% of revenue sources Taxes, state payments or fees probably account for 80%

Capture the key elements Summarize remaining “other” amounts and focus

Major Category HistoryRevenues Jan Feb Mar Apr May Jun Jul

Taxes 8,500,000 7,000,000 3,500,000 750,000 1,000,000 2,000,000 1,000,000

State $$ 250,000 200,000 200,000 200,000 250,000 300,000 300,000

Other 150,000 150,000 250,000 275,000 400,000 400,000 400,000

Total 10,900,000 7,700,000 4,383,000 1,625,500 2,250,000 3,400,000 2,450,000

Expenses

Salaries 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000 2,000,000

Other 300,000 200,000 400,000 500,000 400,000 450,000 500,000

Debt Svc 2,000,000

Total 2,600,000 2,500,000 4,750,000 2,950,000 3,045,000 3,325,000 3,250,000

Net Cash 8,300,000 5,200,000 -367,000 -1,324,500 -795,000 75,000 -800,000

Multi-year View

Averaging multiple years removes aberrations Build history for forward projections

Historical percent of flow is used on new forecast

Tie the detail and summary sheets for efficiency Layering sheets allows for research on aberrations

Expense Focus

Focus on monthly expenditure needs Eliminate the need to invest to each liability Monthly payroll needs Monthly payables needs Semi-annual debt service needs

Meet the monthly need with one early investment Place the maturity before the first known liability Use liquid/short investments to further target each liability Reduce cost of safekeeping while increasing effectiveness

Translating the Information into Action

S M T W TH F S1 2 3 4 5 6 7

8 9 10 11 12 13 14

15 16 17 18 19 20 21

22 23 24 25 26 27 28

Payroll $1mm

Payroll $1mm

Payables $250,000

Payables

$250,000

Payables

$250,000

Payables

$250,000

Entity needs $3 million a month for A/P and payroll costs.

Investment matures on 2nd and is available for rest of month.

Cash Flow Structure Creates the Portfolio

Maturity Date Amount

Liquid (now to 6 mos.) $3,000,000

6 months $ 500,000

7 months $ 500,000

8 months $ 500,000

9 months $ 500,000

10 months $ 500,000

11 months $ 500,000

12 months $ 500,000

14 months $1,000,000

18 months $1,000,000

24 months $1,000,000

$9,500,000

Expense Approach

This entity has two debt service payments: February and August.

Funds for debt service flow in from tax payments first 6 months.

Balances build in these front months.

Keeping funds liquid leaves them at the lowest possible rate.

We need to make these funds work.

Using the Information

An overview of the cash flow needs allows the investor to look ahead.

The flow in Jan. alone covers the February payment.

The net balances of each other month can be invested 11, 9, 8 and 6 months.

A General Fund Sample

We use the excess balances not needed for the next month and extend.

Three excess balances result in 3-month investments.

The cash flow knowledge allows Sept. to be extended to 8-month investment.

Either route gets to the Core

01,000,0002,000,0003,000,0004,000,0005,000,0006,000,0007,000,0008,000,0009,000,000

10,000,000

1 2 3 4 5 6 7 8 9 10 11 12

A view to the balances of cash throughout the year

A minimum balance across the year may be a “core”

This entity has never gone less than $2,000,000. - this is our ‘core’

Define and understand the core Cores can be invested longer knowing that there is little chance of using that

cash

Core

Setting the Maturity and WAM The cash flow defines limits

The maximum maturity (flexibility) Defines limits of extension reflects a core and longer time horizon Rarely over three years

The weighted average maturity (control) controls for over-extension WAM provides for adequate funds availability over time

Maximum Maturity

0

20

40

60

80

0

20

40

60

80

Entity A has no core – starting and ending the cycle at zero They can not invest longer than one year = maximum maturity 1 yr WAM should reflect need to stay inside fiscal year

Entity B has a core so they can invest longer Core allows a possible maximum maturity of 2 years Core allows for possible WAM of 1 year

You must understand what the core is made up and if might change

coreNo Core

A. B.

Cash Flowing Capital Projects A recurring problem: obtaining information

Nonrecurring expenditure and unique cash flows

Prior Work with departments for expenditure plans Bond document may have draft plan

Obtain regular updates from departments to prepare

Repetitive projects may shows patterns of spend-outs Most CIP funds spend-outs are bell shaped

Explaining the importance of cash flow helps generate support Impact of additional earnings Verify arbitrage impacts

CIP Cash Flows

Most CIP expenses are bell curve shaped Initial planning, contracts, land purchase, etc. Growing construction costs ramp up Construction slows as end nears Retainage costs and unused funds remain

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

Step 2: Identify Risks

Risks occur in every investment Risks occur within the custody area Risks occur with counter-parties Risks occur internally

Know your risk tolerance level

Risk

You can not avoid risk

You can manage risk

Risk can be used to your advantage Measured risk will increase yield Use credit ratings and limitations for control

“Market” Risks

You are the market

Encompasses all investors Their actions and expectations control actions

Built on investors expectations Rates are decided on by investors and conditions

General ‘Market’ Risk

Market risk is based on the market price

Diversifying reduces your exposure Money will flow from one sector to another for safety or yield

High credit quality reduces exposure High quality retains its value (i.e. UD $ as reserve currency)

In fixed income markets When prices go up – rates go down So, a bull market has rates dropping

Credit Risk Credit risk is the risk of issuer failure

Inability to pay interest or principal

Authorized investments normally face little credit risk Most statutes require AAA ratings or equivalents Limit the maturity to further manage risk

Recognize the media loves a scare – don’t react without cause Do your homework on why prices are moving Talk to several sources and reason it through

Measure and control the inherent risk in securities Create diversification limits

Use CP but restrict to dual ratings and stay under 90 days Understand issuers restraints and strengths

For example: FHLMC and FNMA conservatorship raises credit Measure and monitor bank credit

Monitor bank credit on ongoing basis Use independent bank ratings agencies (Veribanc, Prudent Man) Monitor collateral market value

How to Manage Credit Risk Restrict the portfolio to the highest rating Diversify

Set % of portfolio limits for riskier securities Limit maximum maturities Monitor credit ratings regularly Watch market news

Watch for major sector moves or news Require dual ratings

Two views are better than one Utilize credit rating agencies

Understand when they are being political too! Understand the rating definitions

Monitoring Ratings

Create a control in policy or procedure for downgrades Authorized investments requiring credit rating (such as CP) need to be

monitored constantly

Create your process based on your risk tolerance: The Investment Officer shall monitor, on no less than a monthly basis, the

credit rating on investments in the portfolio requiring a rating based upon information from a nationally recognized rating agency.

THEN EITHER: If any security falls below the minimum rating required by Policy, the

Investment Officer shall notify the ------- of the loss of rating, conditions affecting the rating and possible loss of principal with liquidation optionsavailable within two days.

OR: If any security falls below the minimum rating required by Policy, the

Investment Officer shall immediately sell the security, if possible, regardless of a loss of principal.

Know Your RatingsS&P Moody’s Fitch

Extremely strong capacity – very low expectation of default

AAA Aaa aaa

Very high credit & strong capacity-low default expectation

AA Aa aa

Somewhat susceptible to adverse conditions – low default risk

A A a

Adequate capacity but subject to adverse conditions

BBB Baa bbb

Lowest investment grade BBB- Ba b

Many pools and funds are not rated on these but on ‘volatility’ ratings such as V-1.

Money market instruments (like CP) have similar levels but different ratings (A1/P1).

Procedures for Downgrades

Have a procedure for down-grades including: Disclosure to supervisor or governing board Consider the conditions of the downgrade Consider your maturity on the security Immediate sales often do not make sense

Understand what the ratings mean Investment grade goes to BBB- at S&P Investment grade goes to BBB at Fitch Investment grade goes to Baa at Moody’s

Liquidity Risk

Liquidity Risk The risk of not having cash when needed The inability to sell security when needed for cash

Liquidity is reduced with longer maturities

Liquidity is reduced in smaller issues Some agency paper is sold in small issues and you could own the

whole issue – no problem if you can hold to maturity

Public funds’ biggest perceived risk Danger that it forces many to stay TOO liquid

The Lure of Lazy Liquidity

It is December 2010, Pools yield 0.16% 6 month CD yields 0.60% ( FDIC 0.85%) 1 year CD yields 0.75% (FDIC 0.85%)

In 6 months $1mm= Pool = $800 in 6 months 6 Mo CD = $3,000 - $4,250 You just had a $3,450 opportunity loss

Managing Liquidity Risk

Don’t be liquidity dependent Being totally liquid puts you at the lowest rates

Do your cash flow and invest to it Stick with the program

Create a liquidity buffer Be practical and prepare for the unexpected

Use liquid investments High credit quality always increases liquidity

Watch the size of the issues On agencies the small issues will not be as liquid

Price and Volatility

Market Risk The risk that market prices will fall Lower prices threatens liquidity

Can you take a loss by policy? Risk that if sold you recognize a loss of principal

“Unrealized” loss versus “realized” loss

Volatility Risk (VIX = the risk index)

The risk of significant changes in market prices Higher the volatility = higher risk Volatility increases with longer maturities, low credit

and structured securities

Managing Market & Volatility Risk

To manage these inter-related risks:

Invest to your cash flow needs in the short-end Purchase high credit quality Establish maximum maturities suitable to sector

Ex: keep commercial paper under 90 days

Maintain a shorter weighted average maturity Minimize embedded options diversify

Event Risk

Event Risk An unforeseen change that affects markets. Moves markets especially with uncertainty

Event risk is everywhere Lehman, AIG, Stanford, Madoff Europe Health care Weather impacts on commodities Auto industry Afghanistan Political change Sovereign and local deficits/defaults

Managing Event Risk

Diversification is the key Not all eggs in one basket Diversify banks, pools, funds, market sectors

Prepare for the worst Imagine the worst and have a plan for it

Extension Risk Extension Risk

Risk that securities lengthen in maturity unexpectedly

Primarily found in mortgage backed securities When mortgage rates rise people do not refinance When people don’t refinance the pay-down horizon extends

Callables can have a short-term extension risk Only if you buy it assuming a call Always assume your risk is holding to maturity Reporting must reflect stated maturity to show total risk

Managing Extension Risk

Use mortgage-backed securities only in suitable long portfolios Portfolios always have to be able to hold to maturity

Diversify among market sectors

Report WAM based on stated maturity Maximum risk is if it goes to maturity

Amortize callables to the call Reflects the risk of the call for amortization cost

Reinvestment Risk Re-Investment Risk

Risk that reinvestment will be at lower rates Primarily in callable securities

when they are called as rates fall Reinvestment of proceeds will be at lower rates

Do not assume a call If not called will it affect your liquidity?

You will be rewarded for the callable risk Using risk to your advantage

Managing Reinvestment Risk Diversify and use some callables

Consider call risk to add yield

Insure initial yield covers reinvestment risk

Amortize to call Creates a par bond which is more valuable If it is called there is not a principal loss

Managing Collateral Risk

MAJOR NEW ISSUES IN COLLATERAL

FDIC and collateral issues

Bank Collateral Securities pledged to repay a debt Deposits protected by FDIC and collateral Covered by Public Funds Collateral Act

(Local Government Code, Chapter 2257)

Manage the risk by answering: What is acceptable collateral to me? Is there enough of it? Is the collateral mine – can I prove it?

Big Changes in Collateral

Basel III Accords Quality level on the pledged collateral Reduces bank ratings Pushing banks away from securities

Forcing the LOC

Public Unit FDIC Coverage

Based on type of account All time and savings accounts = $250,000

Includes NOW and money market accounts

All demand accounts = $250,000 Includes interest bearing and non-interest bearing

New rules based on location of bank If the bank is outside the state all deposits are lumped together This has changed from ‘headquartered in state”

75

FDIC Coverage

Political Unit Accounts If created under express authority of law Has some function of government delegated If it executes exclusive control of its funds for exclusive use

Special cases 4a and 4b corporations Water supply corporations

76

An FDIC Example

Under the changed rules: Entity X has:

$585,000 in demand accounts $195,000 in time and savings accounts The MUD has $445,000 in FDIC coverage

FDIC coverage is calculated $250,000 (demand) + $195,000 (savings)

77

Collateral

Collateral covers deposits above FDIC insurance

Collateral is pledged not owned

Set the margin at 102% to protect from price volatility Districts require 110% on MBS (mortgage backed securities)

Establish independent custody

Require independent monthly reporting 2013 change in PFCA requires entity to request reports

78

Collateral

Define “acceptable” collateral Define your authorized types of collateral Reference collateral in your policy and in your bank RFP

Demand sufficient collateral Margin requirements of 102% (110% MBS) Monitoring by the bank Marking-to-market

Verify that collateral is pledged to your entity Safekeeping receipts and reports from custodian Independent custodian will have to work for you

79

FDIC Coverage

Search on: public unit insurance

Is your collateral report coming from the custodian?

If not how secure is it?

Using a Rating Service

Bank Rating Services:

-Best

-Highline

--Veribanc

Rating services rate ‘CAMELS’

Capital

Assets

Management

Equity

Liquidity

Systems

Types of Collateral Risk

Define the authorized collateral (in policy and RFP) Obligations of the US Government, its agencies and

instrumentalities, including mortgage backed securities with CMOs passing the bank test

Monitored and maintained by the bank at all times.

Choose and understand your options within law Surety bonds Treasury Notes and Bills US Agencies Rated Municipals Letters of Credit

Custodian Duties

In any event of default

Take control of collateral

Hold the collateral under your instructions

Sell the collateral if applicable Paying your 100% portion Return excess to bank

The Fed as Custodian

Standard Pledgee Agreement Form is used The Fed will not sign a collateral agreement

Supplements the Bank Collateral Agreement Reference the Circular 7 in your agreement

Fed will ask for authority to use e-mail (FedMail) to contact you

Recent Circular 7 Change Notification

Little impact but assures control by entity through custodian The pledgee is responsible Contract must require bank to monitor and maintain colalteral levels

Treatment of principal Principal will be held in non-interest bearing account until the earliest of:

New securities are substituted Principal is released by Pledgee (public entity) Principal collected by pledgee on event of default

Treatment of MBS (amortizing book-entry security) Principal will be held in non-interest bearing account until the earliest of same

three conditions

Treatment of interest Interest goes to the Pledgor (bank) unless written notification of event of default

Federal Reserve as custodian

Circular 7 Pledgee Agreement

Authorizing use of e-mail for contact purposes

Surety Bonds

Surety bonds are insurance policies

Verify: Company (and its strength)

Recipient (is it the District?)

Terms (tie it to the contract)

Letters of Credit

Initiated for State CD business

LOC normally issued by FHLB backed by pledged unrestricted securities or bank credit

Created to replace collateral and PFCA

Collateral Pooling

Final Rules Published 10/10 New move afoot to change Rules for a practical program

Voluntary – bank and public entity Not applied to counties or higher education

Exclusion of higher ed. not in 2257

All Texas publicentities using theone bank

Bank pledges Comptroller actsenough for whole as agent forGroup entities

Repurchase Agreement “Collateral”

Differentiate this collateral type in your policy

In Repo district owns the securities

The same requirements apply Define the authorized collateral types Establish the required margin (102%) Establish third party safekeeping

Managing Risk

Custody and Safekeeping Risk Risk to your proof of ownership

Proving your ownership Risk of a custodian restricting access

Key safety points Independence Reporting to you directly Custodian should verify authorized collateral and margin

Applies to: collateral pledged to you (custody) securities you own (safekeeping)

Custodians

Custodian has fiduciary responsibilities Usually you agree to/approve a custodian

Safekeeping agents simply hold securities Usually you chose custodian

Key factors for both: Independence on trades or pledgor Custodians and agents should report directly to you

What is a Safekeeping Account?

Not a “bank account” for funds In clearing/safekeeping department Account is in district’s name Totally electronic

Places your owned assets in care of an agent Agent is the bank

Securities remain in ‘Street-name’ Generic ‘nominee’ name to ease transactions/transfers Client is actual owner – nominee holds title

Fees are required Hard-dollar is a direct fee paid monthly Account analysis charge is paid by compensating balance

Safekeeping AccountsDepository Bank

Relationship

Interest Bearing Money MarketAccount Account

Safekeeping Account

Safekeeping is tied directly to an account

Safekeeping accounts are not regular bank accounts but must be tied to a demand deposit account (DDA) so that money that buys a security can only flow back to the same account.These accounts are in the securities clearing section of the bank and assigned by name.

Using Your Depository as Your Safekeeping Agent

Security is purchased from a broker

Broker’s bank sends security to your bank’s safekeeping department

Safekeeping compares security received vs. trade ticket from you

Did it agree?

Yes

no

Returned to broker (DK) to check

Returned to broker to correct

Safekeeping accepts security and debits the bank (DDA) account

Using A Second Depository as Your Safekeeping Agent

Security is purchased from a broker Broker’s bank sends

security to second bank’s safekeeping department

Safekeeping compares security received vs. trade ticket from you

Did it agree?

Yes

noReturned to broker to correct

Safekeeping accepts security and debits the 2nd bank’s DDA account

Money must move from your depository to safekeeping bank

no

Money to second bank’s DDA account Since the purchase

and all income must go to a DDA account – the 2nd

bank must establish a DDA account also

If the banks have a relationship the depository bank can avoid establishing a 2nd bank DDA account.

Investing: Part of Cash ManagementInvoicing and

Collection Debt Issuance

Cashiering Disbursements

Investments Safekeeping Banking

Various components of

the cash management

process.

Are the controls in place for each? Name three for each.

Typical Safekeeping Costs Clearing

FRB DTC

Safekeeping FRB or DTC Par or cusip

Income Distribution Coupons paid Maturities calls

How are they charged?

Why is it important to know?

When do you use this information?

How can you reduce the fees?

Safekeeping Services

Safekeeping need not be at banking services bank Banking services bank is convenient Other banks may be needed or less expensive A second bank requires ongoing transfers and an account

Agreements Depository Agreement covers safekeeping services Includes a collateral agreement if funds are over FDIC Master Agreements can be used for banking services

Portfolio Risks

Over extension control Set a maximum weighted average maturity Set a maximum maturity

Price control Always use competitive transactions Only way to assure ‘market’ price

Safekeeping control delivery versus payment (DVP)

Always diversify to spread risk

Always report on a timely basis with info not just detail Show asset allocations by maturity and market sector

Non-Market Risks

Counterparty risk Broker background checks FINRA registration Independent safekeeping outside brokerage

Banking risks Reconciliation within 30 days Verify availability of funds Continuously monitor cost of services with account analysis

Employee risk Separation of duties Oversight and cross training Cash controls like numbered receipts, safes, assigned tills

Technology’s Risks

Employee controls Pin numbers and separation Limited access to cash and programs Sole use PC for bank transactions

Bank fraud controls Filters/blocks on ACH Payee positive pay

Step 3: Set Strategy

Macro strategy Policy statement from passivity or proactivity Includes setting WAM and maximum maturity Requires annual review Must be flexible enough to adjust to market and internal

conditions

Market Strategy Changes daily and requires market information

PFIA Required Strategy A strategy should be written

And preferably adopted by governing body Set strategy by portfolio(s)

Or one commingled portfolio Including in the policy ties the two closely

Should describe how you achieve: Objective of investments Suitability of instruments Safety Liquidity Diversification Yield

Sample Strategy for aShort, Passive Portfolio

The district may maintains one commingled portfolio for investment purposes which incorporates the specific needsand unique characteristics of the funds grouped represented in the portfolio.

The primary objective is liquidity and reasonable yield. Authorized securities will be of the highest credit quality. When not matched to a liability it will be short term and liquid. The portfolio will be diversified to avoid market and credit risk. Diversification requirements can be met through a pool.

Maximum WAM is 120 days.

Sample Debt Service Strategy

The investment strategy for debt service funds shall have as its primary objective the assurance of available funds adequate to fund debt service obligations on a timely basis.

Successive debt service dates will be fully funded before any extension of investments are made.

Successive funding is critical Too often these funds are kept liquid losing yield

Benefits of Commingling

Think through the portfolio structure Radically different fund types need a separate policy

Separate portfolios Require separate accounting May cause liquidity problems Can reduce yield by requiring liquidity balances

Commingled portfolios Can still address unique needs of funds Smaller liquidity needs may allow more extensions Reporting is simpler

Addressing More ‘Action’

Pro-active portfolios may change their ladders

Addressing sales and swaps Securities may be sold before they mature if market conditions

present an opportunity to benefit… The investment officer will continuously monitor market

conditions…

Addressing loss A loss may be taken on a swap of securities if the loss is

regained within a three-month horizon on the trade. No realized loss may be taken on a straight sale of a security.

Step 4: Policy Development

Your first line of defense

Policies are working, dynamic documents

Must be reviewed and adopted annually by Board

Policies show prudence and pro-active management to Rating agencies, capital markets and citizens

Policy Objectives

Policies combine legal and procedural elements Be concise and clear Policy is not a manual

Create flexibility with limits for changing conditions

Create controls

Creates authorizations and responsibilities Who is authorized to do what? What must each entity do and when?

Policies are Built on Fundamentals

Not a boilerplate document – tailor to your needs

Cash flow Sets maximum maturity Sets maximum weighted average maturity Sets benchmarks

Risk tolerance identification Chooses the authorized securities Sets internal controls

Initial Key Questions Portfolio structure

Commingling all funds or separation by type of funds?

Accounting and Reporting Needs Separate entities and funds and responsibilities

Scope of authority Designation of authority by governing body Training needs and budgets

Brokers and critical competition

Governing body interpretation of risk What performance do they expect? Does risk and conservative action mean the same to them??

Writing the Policy Internal review

Cash flow Resources available (tech and personnel) Accounting needs Market information systems Banking arrangements and contracts Safekeeping Supervision and oversight

Legal and statutory review Be aware of different type entities Being legal doesn’t mean it’s reasonable

Beware of special interests in the law

TEA LOCAL

Investment Authority Approved Instruments Objectives

Safety, Liquidity, Diversity Monitoring market prices Monitoring credit changes Funds/Strategies

Operating funds Agency Funds Debt Service Funds Capital Projects

Safekeeping and Custody Broker/Dealers Soliciting CDs Interest rate risk Internal Controls

Legal and Local Policies

Possible Additions to Local

Scope Annual review Investment officers Standard of Care Collateral Broker Requirements

If not policy inclusion – procedural control

Policy: Objectives

Do more than just state the objectives Safety, liquidity, diversification and yield

Define objectives at macro level Tie the investments to the cash flow

Sets the tone for active-passive choice

If safety is your goal Tight limits, extreme credit limits, etc.

If safety with yield is your goal Wider security choices and longer terms

Yield versus Rate of Return Beware of the specificity of the terms

Connotes intent to market participants/brokers

Yield Buy-and-hold, not a trading portfolio, conservative “Yield” based on purchase price and remains to maturity

Rate of Return Market driven, active management, often indexed “market return” based on the market price as it changes over

time

Policy: Assigning Responsibilities

Clarification for each involved party Concise listing aides comprehension Summary in one place avoids confusion

Statutory and policy requirements outlined Designating responsibilities

Governing body Investment officers Investment committee Auditors Advisers

Sample Responsibilities

The Investment Officer The [--position----] is designated as the Investment Officer and is

responsible for all investment decisions and activities.

The Officer will receive training… The officer will develop procedures and controls… The officer will not be personally liable if the policy and

procedures are followed. The officer will prepare monthly and quarterly reports… The officer will disclose any conflicts…

Policy: Ethics and Disclosure Ethics and Conflicts of Interest

Standards and Disclosure

Officers will refrain from personal business that would conflict with proper and impartial execution of their duties. All personal and business relationships with entities doing business with the City will be disclosed.

Policy: Authorized Investments

Limit specifically by investment type

Require legal changes require local governing body re-adoption

Set a maximum maturity by type

Set credit requirements

Need not include all legally authorized types

Tailor the list to your entity’s needs

Sample Language

Define the security Obligations of the US Government, its agencies and

instrumentalities, excluding mortgage backed securities, with a stated maturity not to exceed ---- years. “Stated” maturities are critical in callables, etc.

A1/P1 or equivalent rated commercial paper, rated by two nationally recognized rating agencies not to exceed 90 days to stated maturity. Set your maximum maturity to recognize market risk With CP the market risks increases measurably after 90 days

Depository CD

Limitations will differ with state statutes

May be afforded collateral Define collateral requirements in policy section

On merger or acquisition if bank FDIC will be extended Coverage will extend to first maturity date

Sample: Insured or collateralized CD of banks doing business in the state

and collateralized in accordance with this policy, not to exceed ---- years.

Brokered CDs This is a security traded like any security

Can be written outside States Often pushed as safe held by broker – contradicts DVP

No collateral is available Stay under FDIC coverage

On merger or acquisition there is no extension of FDIC coverage Must be monitored weekly (Friday am)

FDIC insured brokered certificates of deposit securities from a bank in any US state, delivered versus payment to the [City] safekeeping agent, not to exceed one year to maturity. Before purchase, the Investment Officer must verify the FDIC status of the bank on fdic.gov (bankfind) to assure that the bank is FDIC insured.

Brokered CDs need special attention –mergers and acquisitions can leave you over-the-limit.

Not the same as YOU being in two banks that merge or acquired.

Internal Control for Brokered CDs

FDIC handles these two types of CDs differently Protect yourself FDIC provides NO reprieve for mergers and acquisitions

The Investment Officer, or Investment Adviser, shall monitor, on no less than a weekly basis, the status and ownership of all banks issuing brokered CDs owned by the [City] based upon information from the FDIC.

If any bank has been acquired or merged with another bank in which brokered CDs are owned, the Investment Officer, or Adviser, shall immediately liquidate any brokered CD which places the [City] above the FDIC insurance level.

Are bank accounts authorized?

You make an investment decision with funds in a bank Should it be an authorized investment for clarity?

Account for low rate environments when a large % may be needed

Account for funds left in the ECR as an investment

Define for use accounts in all state banks FDIC insured or collateralized interest bearing accounts in any bank in

the state, collateralized in accordance with this Policy

Security Diversification Tables An optional control to assure diversification

Security Max % of Ptf.

Treasuries 80 % Agencies/Instrum 70 % Depository CD 25 %

% by bank 10 % CP 20 %

% by issuer 10 % Constant $ Pools 100 %

% of pool 10 % MMMF 40 % Bank Accounts 60 %

These are ‘maximums’ not designations. Allow for changing conditions.

Monitoring Ratings

Authorized investments requiring credit rating (such as CP) need to be monitored

Add to the policy a process and/or action for monitoring the ratings

Two alternatives based on your risk tolerance: The Investment Officer shall monitor, on no less than a weekly basis, the credit

rating on investments in the portfolio requiring a rating based upon information from a nationally recognized rating agency…..

If any security falls below the minimum rating required by Policy, the Investment Officer shall notify the ------- of the loss of rating, conditions affecting the rating and possible loss of principal with liquidation options available within two days.

If any security falls below the minimum rating required by Policy, the Investment Officer shall immediately sell the security, if possible, regardless of a loss of principal.

Policy: Safekeeping

Its criticality merits its own policy section

Total control requires independent safekeeping

Require receipts to be matched and maintained

Securities owned by the district will be safe-kept at the banking services depository or an approved custodian and all securities will be settled delivery versus payment (DVP) to assure proof of ownership. The safekeeping bank will not be used as a broker in order to guarantee DVP settlement.

Policy: Owned Collateral Section

Repo collateral is owned by the entity

Require the ‘Bond Market Master Repurchase Agreement’

Dictate what will be authorized collateral You set the requirements

Dictate the margin Agreement and industry standard is 102%

Dictate independent custody

Policy: Counterparty Section Counterparties include brokers, banks and pools

Requirements are set because they are selling you a transaction Covering any body which is selling a transactions

Broker/dealers, banks, pools

Establish qualifications

Establish monitoring

Establish a reasonable number of counterparties Dependent on your time and need

Policy: Adoption

Investment Policy and Strategy Adoption Adoption assures that the governing body is on board Annual adoption by resolution is required

The Policy and strategy shall be reviewed and adopted no less than annually by the Board. A written resolution approving that review and noting any changes to the Policy or strategy will be recorded by the Board.

Step 5: Procedures and Controls

Procedures support the Policy

Controls are needed to manage risk

Keep them short and practical

Key areas: Collateral and safekeeping Trading procedures and counter-parties Settlement by delivery versus payment

Control and Procedural Areas

Signatories Custodians Ethics Investment decisions Investment procedures Accounting and reporting Wires Documentation Strategy

Reporting

Investment reporting is about performance and risk

Statutes may address reporting – you must address it

Set the standards and requirements Timing – monthly and/or quarterly Book Value - Amortization and accruals required Pricing – independence Benchmark - for risk measurement

Reporting Procedures/Controls

Detail information Detail on each position/investment

Beginning and ending book and market Description, par, maturity, yield, and book and market value

Earnings (accruals plus net amortization)

Summary information Sum of book and market values plus realized gain/loss Total earnings for portfolio Change in market value (to measure volatility) Overall weighted average maturity (WAM)

Performance reporting Benchmark performance for the period Overall portfolio yield for the period

Counterparty Control Investment officers must monitor the counter-parties

Annual review of registrations State and FINRA registrations CRD annual check for any actions taken against the firm/individual

FINRA.org – ‘Broker Check’

Annual review of their usefulness How many times have they given the best price level

Annual review of financials Not really necessary because of DVP – no true risk represented Critical if you allow broker safekeeping (high risk)

Broker/Dealer Controls

Limit the number of broker/dealers for efficiency Minimum activity or a small portfolio rarely need more than 3 Always have three to assure competition More active portfolios in different markets may need 5-7 Don’t let brokers take up your whole day

Certification requirement? Texas requires counter-parties to read and certify review of the policy Good control that the counter-party knows your guidelines

Broker/Dealer Requirements Gather and maintain background information only

firm information contact broker information delivery instructions public client references Annual audited financials (if required) Certification of policy

Differentiate between secondary and primary brokers

Non-Primary Brokers Identify market sector involvement Must sync with your needs

FINRA Broker Check

Finra.org

Self regulatory

Annual check

CRD# or name

Depositories Controls Designation of depository optional

Banking is a key element of investing

By depository law must be competitively bid at least every five years Primary banking services depository

Recognize right to use other depositories for investments

Incorporate right to go outside ETJ Entity reserves the right to designate a primary banking services

depository outside its ETJ. Satisfies legal requirement for a resolution to so state.

Remember Investing is Risk Management!

Linda PattersonPatterson & Associates

linda@patterson.net