NOTES FOR CASH MANAGEMENT EXAM:
Introduction to public investing:
Most of the fed govt’s impact on the country’s financial markets results not from
investment practices but from debt management functions associated with the issuance of
Tbills, notes and bonds to finance federal operations.
The novice investor should study elementary fund types to understand all financing
operations of a govt entity.
An area of fed legislation that directly affects pub investors in the market for repos is the
fed bankruptcy code.
An investment officer’s authority to purchase sec w/ public funds depends on a
framework of legal authority.
While the elected treasurer fosters some public accountability, many modern govt
theorists suggest that this ministerial function is performed better by an appointed official
selected on the basis of technical expertise. Generally, electoral accountability is an all or
nothing insurance policy against flagrant corruption or incompetence.
Legal requirements of investing:
four bodies of law – market; state laws; local or organization-specific ordinances and
case law and legal theory surrounding the obligations of fiduciaries and investment
general securities law– first law of securities transaction: buyer beware
federal bankruptcy law – 1984 amendments to the bankruptcy statute exempted
repurchase agreements from the automatic stay provision (which is to prevent
creditors from seizing assets of the bankrupt firm)
constitutional and statutory – an investment officer’s authority to purchase securities
with public funds depends on a framework of legal authority
local government may derive their investment authority – a) home rule entities
permitted to set their own course through local charters; b) through general
investment statutes of the states whereby legal lists of allowable securities define the
field of investment options available to local govt
Objectives of investment:
Investment of public funds is a discipline. The actions of public officials responsible for
investing public funds must be guided by knowledge, skills, systems, policies,
procedures, confidence, integrity and commitment that be described only as professional
Key elements of any investment process – four fundamental components:
1. An investor’s objectives, constraints, preferences and capabilities must be identified
and specified explicitly in the investment policy.
2. Investment opportunities are identified and strategies are formulated and
implemented through the purchase of financial securities and related instruments in
3. The investor’s circumstances, market conditions and relative values of securities are
monitored, results are documented and reported.
4. Portfolio adjustments are made in response to new objectives and changing
circumstances and results.
Eleven steps to prudent investing:
1. Identify the entity’s obj., constraints, preference and capabilities.
2. Develop investment policies.
3. Develop administrative systems and internal controls.
4. Prepare a cash forecast.
5. Determine the investment horizon.
6. Establish an investment outlook and strategy.
7. Analyze the yield curve – once the cash forecast and investment horizon have been
completed and the economic outlook has been formulated so that basic strategies are
considered, investment managers then must determine whether longer or short
maturities are preferable.
8. Select optimizing instruments.
9. Monitor the markets and investment results. – an impt part of this process is internal
and interim reporting.
10. Report results – to successfully report results, must describe the frontier of
opportunities that prevailed; explain basic strategies; describe interaction among
market forces, positions taken, shifting cash flows and actual results.
11. Adjust and rebalance the portfolio accordingly.
Political and legal considerations:
The investment prog must be in conformance with fed laws, state statutes and local
ordinances and internal policies and procedures.
Besides legality, the govnt’s most foremost investment objective must be the safety of
Legality – safety – liquidity – yield – diversification – suitability (inv s/b appropriate for
particular purpose that funds have been received)
Process of establishing investment policy:
1. Explicit statement of objectives – objectives – preferences – statutory constraints and
2. Delegation of investment management authority - Authority to make investment
decisions comes from state statutes, local ordinances and charter - identify what’s
being followed; who’s responsible of investment action.
3. Identification of fund types and investment horizons – e.g., long term bonds s/b
limited to those funds with long horizons.
4. Identification of appropriate instruments – e.g., in small govnt, commercial paper
transactions would be inappropriate b/c funds are too limited to permit diversification
of unsecured instruments; many govnt may wish to preclude purchases of notes and
bonds with maturities exceeding one to two years.
6. Active vs. passive management preference.
7. Diversification (by inv instr, by financial institution, by maturity scheduling) –
legality and expertise of staff s/b considered
8. Credit or default risk – the risk of loss due to failure of the security issuer or
guarantor is known as credit or default risk – s/b be primary concern. – policy should
require collateralization; specify credit evaluation and ratings by nationally
recognized rating agencies.
9. Authorized securities dealers and financial institutions.
10. Internal controls.
11. Documentation – document specific decisions by investment managers.
Economic cycle: begins with recovery from an economic recession ; initially, rates
remain relatively low; unemployment decline; inflation low, hence, interest rates tend to
be low. During economic expansion, rates tend to increase.
Commercial paper rates tend to increase more rapidly during the later stages of an
Summary – primary purpose of structured system:
assure proper authority – investment decision
discourage unsystematic action
assure appropriate research and documentation
explore all available opp.
provide for strategies that emphasize safety and necessary liquidity first and market
rates of return second
avoid speculation of any kind
maximize public returns in the long run (maximization can mean attaining the market
provide sufficient info for revisions in plans and strategies to adj to ever changing
provide a basis for improved policies and results in the future
3 components of investment statutes:
1. a legal list of allowable securities
2. prudent investor clause
3. mandatory enactment of written investment policies
Such policies should include elements such as risk parameters, cash flow characteristics,
maturity and weighted average maturity limits while considering the unit’s ability to
diversify and the capabilities of its internal and external investment managers.
Considerations – policy drafting:
scope – differentiate short term or operating funds vs. long term – cover all funds?
objectives – sets the tone and direction of inv prog
delegation of authority
prudence – include reference to prudent investor rule
ethics and conflicts of interest
internal controls – inv function
reporting - interim and annual (annual different in scope and direction – not focused
on specific investment – provides broader info and overall long term direction)
financial institutions/brokers/dealers – selection
maturities and volatility
risks (define risk tolerance and parameters – govnt are concerned with risks of default
or credit risk, risk of market price losses, interest rate risk and risks of illiquidity)
default or credit risk – probability issuer will be unable or unwilling to redeem an inv
market price loss results from inv in fixed income sec during a period or rising
interest rate risk – lower yield than current market rate and incur opportunity cost by
the under performing market
liquidity risk – ability to sell an inv before maturity
safekeeping and custody
performance evaluation and operations audit
Prudent person – holds that a reasonably well-informed person, not a professional
investor, or market maker, is the ideal type of person to be held accountable. – standard
less rigorous than prudent expert
Prudent investor – higher standard – often applied to trustees of pension funds
Prudent expert – expected to be knowledgeable in all relevant areas surrounding
investment securities used for an individual prog – where external managers are paid
retainers, the prudent expert standard seems appropriate – cite in contracts with inv
Public entities with sufficient size portfolio are urged to apply the prudence concept to
the overall portfolio – investment prog be designed to anticipate occasional credit or
market risks that can be consciously offset through diversification.
Investment officers acting in accordance with written procedures and exercising due
diligence shall be relieved of personal responsibility for an individual security’s credit
risk or market price changes, provided deviations from expectations are reported in a
timely fashion and the liquidations and the sale of securities are carried out in accordance
with the terms of the policy.
control of collusion
separation of functions
separation of transaction authority
avoidance of physical delivery securities
clear delegation of authority
specific limitations re securities losses and remedial action
written confirm of inv and wire tsfr transactions
written wire tsfr agreement
supervisory control of employee actions
minimizing the number of authorized investment officials
documentation of transactions and strategies (for internal control purposes,
documentation should include a desc of org structure, identification of functions and
employee responsibilities, a step by step desc of the investment transactions and
related funds transfers processes and a complete desc of forms and procedures used to
execute and confirm investment transactions. Limitations on employee authority and
procedures in case of absences should also be documented. Written procedures
should establish employee reporting obligations in case of perceived impropriety or
In designing internal controls, govt should begin by identifying the events and
transactions that make up the investment function to examine potential weaknesses –
prepare a flow chart that describes these activities and how funds flow thru the sys.
Investment authorization is intended not only to protect the govt from the risk of
embezzlement and fraud but also to protect against errors of judgment resulting from
inappropriate selection of securities of insolvent dealers.
When sec. are issued in bearer form, safekeeping is concerned with guarding the physical
sec. in vaults. When issued in book entry form, safekeeping involves the maintenance of
electronic records of ownership by the inst. entrusted as the custodian.
Risk assessment can be accomplished by identifying the type of loss that could occur,
anticipating how it would occur and then estimating possible consequences and
Effective internal controls require written contracts and agreements for all services.
Most govt rely on procedures, surety bonds and faithful performance bonds to control the
risk of asset conversion.
Some govt managers seek to instill healthy skepticism in their acctg. personnel.
Documentation of procedures is a vital element of the internal control system.
A wire transfer agreement can be a stand-alone document or an addendum to the banking
The extent of market price loss considered tolerable should be determined in advance and
accompanied by a contingency plan.
Most govt limit acceptable collateral to U.S. treasury and agency securities – minimum is
102% of assets – this 2% margin is know as “haircut” – for govt securities with long term
maturities, the govnt may require collateral at 105-110% of assets
Brokers/dealers: (an explicit investment policy and written depository retainer agreement
provide a strong basis for legal action in the event of misrepresentation and malfeasance
by a financial inst or brokerage firms and its officers)
Functions of cash budgeting:
1. offers early test of the operating budget
2. used to obtain projections of cash balances (cash forecast) for inv purposes
3. provides the formal financial plan needed to assure compliance with fed arbitrage reg
whenever a govt contemplates short-term borrowing (a formal cash budget provides
tangible evidence of a tax-exempt entity’s need to borrow funds)
Tools for cash budgeting:
bank statements for the previous fy
monthly financial reports from the prior fy
current year budget
cap proj spending projections prepared by engineers
summary of current investment maturities
Notes: any revenue item representing less than 15% of total revenue is unlikely to
materially affect a cash flow projection. Beginning cash balances sets the tone of the
cash forecasting exercise.
Arbitrage: the simultaneous purchase and sale of the same or equivalent security in
order to profit from price discrepancies. The spread between the two prices becomes the
For state and local govt, arbitrage usually relates to the investment of tax exempt debt
Arbitrage rebate/requirement – exceptions:
1. small issuer – no more than $5 million each calendar year – at least 95% used for
2. general six month – all bond proceeds spent within six month
3. TRAN – cumulative cash flow deficit within six months equal to 90% of TRAN
(reserves must be spent first)
4. 24 month construction
5. 18 month spending
6. debt service
Note: it’s possible to intentionally earn arbitrage profits by structuring a tax exempt
bond to technically meet the above but not advisable to do so.
SHORT TERM INVESTMENT INSTRUMENTS:
Money market instruments – most public sector investments are placed in money market
instruments – include U.S. govt obligations (particularly those with maturities of less than
two years); depository instr (CD’s); obligations of US govt agencies; repos, bankers’
acceptances, CP, local govt investment pools.
4 sectors where most public sector cash management are:
government securities – t-bills; agency and instrumentality securities
depository certificates of deposit
local govt investment pools – CD’s’ bankers’ acceptances
U.S. securities – primary instruments of the Fed Reserve Board; changes in govt
securities’ yields and prices set the tone, pace and directions of credit markets worldwide.
U.S. govt cannot default on a specific maturity or credit instrument – even in periods of
massive fed deficit, the Treasury will refinance any outstanding maturing debt thru
issuance of new credit instrument – from a credit standpoint, Treasury securities are
riskless instruments – carry the least rates of return of all fixed income credit instr.
Treasury issues two basic kinds or 3 types of securities/credit instr.:
1. Tbills – bears no specific interest rate – originally issued at a discount – all Tbills
mature on Thurs unless holiday – auctioned in two series, weekly and monthly –
virtually risk-free and very liquid
2. Tbonds and notes (coupon securities) – a telephone market – no centralized
marketplace of clearinghouse – transactions center around a group of primary dealers.
Notes are issued for original maturity of 2 to 10 yrs and carry that label only b/c of fed
Treasury coupon securities are called notes or bonds but their actual security features
are identical regardless of their label.
Govt securities dealers do not charge a commission for their services – compensated by
spread bet. the price they pay for securities (bid price) and the price they receive from
customers and other dealers.
In stable markets, the spread narrows. In bull markets (interest rates are down) spread
narrows. When interest rates are changing rapidly and securities prices are volatile,
the spread widens.
Bid quotation – discount interest rate at w/c dealer is willing to purchase Tbills – always
will be an interest rate higher than asked (or offered) rate.
Price and yield are inverse – so a higher bid rate means lower prices. A dealer always
bids a lower price (higher yield).
Spread – the diff bet. bid and asked prices – represents a dealer’s gross profit margin for
a given security.
Bonds are issued with original maturities of 10 yrs or more.
Zero coupon bonds – pay no interest until maturity – separate coupons from principals
and interest payments of a bond – investors can lock in interest rates – changes in interest
rates have greater impact on zero coupon bonds
Zero coupon securities – issued at a discount and makes no periodic interest payments –
rate of return consists of gradual accretion of the principal of the security and is payable
at par upon maturity.
Yield to maturity – is the effective compound annual return if investors could purchase a
security and reinvest the coupons at the same interest rate.
When rates decline, prices of money market securities increase, producing additional
income from capital gain; however, the holding period on a fixed income security
generally will be less than its original yield whenever interest rates increase.
The main investment risk associated with the various forms of Treasury zero
coupon securities is market risk (not credit risk).
Financial future – contract to buy or sell specific standard instrument during a specific
future month at a price determined in a central, regulated marketplace – appropriate only
for those govt operating with risk exposure to changing interest rates and w/ supportive
political and org. environments.
Agency securities – only those backed by the full faith and credit of the US govt; -
guaranteed by US Treasury; others are referred to as govt sponsored corporations or
The difference in agency securities and treasury securities is their liquidity and
Govt sponsored enterprises (GSE) – privately owned corp with a public purpose – these
are financial intermediaries established by fed govt to fund loans to homeowners, farmers
Unlike income from direct US obligation, income from govt sponsored corporations are
fully taxable at the state level.
IO’s and PO’s (interest only/principal only) are not considered appropriate for public
Marketing of new agency issue arranged three ways:
1. fiscal agent or financial intermediary
2. place issue directly with one of more syndicates
3. conduct a public sale
Most commonly used govt securities:
1. Farm credit consolidated system-wide discount notes
2. FHLB discount notes
3. FHLMC (Freddie Mac) discount notes – mortgage credit for residential housing
Coupon sec. w/ maturities under 2 yrs:
1. Fed Natl Mortgage Assoc. – Fannie Mae – first modern federally chartered corp
owned entirely by stockholders. – enjoys a strong secondary market in the short term
2. Fed Farm Credit System Banks
Variable rate notes – unlike conventional coupon securities, pay interest rates that can
fluctuate during life of security – indexed to some common money market instrument.
Settlement payments for early morning secondary market transactions may be made on a
same day or next day basis.
Although banks operate under the federal charter w/ govt supervision, the securities are
not guaranteed by the US govt.
SBA – prog designed for economic dev, not investment – not liquid – bought simply as a
buy and hold proposition
Declining interest rate market is normally an advantage to long term securities investors.
General caveat to investors in agency and instrumentality securities: always obtain
an independent second price quote from a competing dealer before you buy.
Callables – security is callable when the issuer has the option to repay part or all of the
issue early by paying some specified redemption price to the holder – while some issues
are non callable for life, other issues are callable after a specified number of years.
Shorter callables are callable at par; therefore investors should avoid purchasing
these securities at a premium unless there will be time to amortize the bond w/o
decreasing the yield..
Step-up – type of callable w/c will have a call date at w/c time it may be called or will
step up to a higher coupon.
Floaters – pay variable rate linked to a rate setting mechanism based on an index of
current money market rate – attractive b/c they have higher yield due to the lesser credit
quality and the potential increase of Tbill rates
Inverse floater – very risky – not recommended for public funds.
1. Collection services – primary obj. is accelerating cash receipts – facilitate the deposit
of receipts into the bank in the shortest possible time - most popular are wire transfers
and lock-box system.
Fed Wire is used more extensively for the ff. reasons:
transaction costs are generally less
daily settlement between banks
all banks may participate
security of the transfer is guaranteed by the Fed Res
Collection float – tag lag caused by the normal processing of cash receipts thru the mail
and the govt’s internal procedures – occurs at three critical points in processing:
1. mail time bet. mailing and receipt of a check
2. internal recording and processing time to prepare for deposit
3. check clearing time bet deposit of subsequent notification by the bank of fund’s
A. ACH – was developed as a means to reduce check volumes’ virtually all are operated
by the Fed Reserve Sys; even those privately operated still use Fed Reserve for settlement
– all electronic entries bet. ACH must travel over the Fed Wire – all ACH have one day
availability, regardless of the originating and receiving banks’ locations.
ACH fundamental rule – the flow of info always moves to the originator from the
receiver or from originator to the receiver.
Benefits of ACH:
1. reduce preparation of invoices
2. eliminate mail float
3. eliminate processing float
4. reduce check clearing float to one day
5. reduce bank processing charges
B. Preauthorized checks (PACs) – similar to ACH – customers enter into agreement to
have checks drawn against their accounts at specified intervals.
C. Lock-Box Systems – two types, wholesale (used for low volume, higher dollar
payments were some degree of customization may be needed); and retail (high
volume low dollar payments)
D. Wire Transfers
E. Armored car
F. Night depositories
G. Coin counting
Cash concentration techniques:
1. Depository transfer checks – signature-less
2. Electronic depository transfer check
3. Over the counter payments
2. Disbursement services – objective is to retain the available funds for a longer time
period – can be accomplished by lengthening or maximizing the disbursement float
Disbursement float time lags:
1. delivery float – time elapsed bet recording of a disbursement in the govt accounting
system and the time the recipient (vendor) receives the check
2. processing float – time required by the recipient to process the check thru its internal
accounting procedures and deposit the check in its bank
3. check clearing float – time elapsed bet the deposit of the check by the recipient and
the date the check is deducted by the bank from the govt account
Wire transfers used for disbursements will reduce the float – the true advantage is that
there is a definite period during w/c funds can remain vested – also important to initiate
investment transactions. Note: Originating wire transfer generally costs higher than
receiving a wire transfer.
Daylight overdrafts – accdg to Fed Reserve, about 20% of wire transfers are daylight
overdrafts – daylight is a term to signify that the incoming wire should be received by the
close of the Fed Wire and the entire system is back in balance again.
Policy on daylight overdrafts: each bank perform a self assessment of its own credit
worthiness: capital, assets, management, earnings and liquidity (CAMEL)
Other disbursement services: “payable thru drafts”; ACH; direct deposits;
concentration/zero balance account
Check presentments take place in four ways:
1. Fed Reserve cash letter
2. local clearinghouse
3. direct sends
4. over the counter
3. Credit Services – line of credit allows govt to borrow money from a bank at any time
up to a predetermined limit – not cost effective if used infrequently
Four lines of credit:
2. swing line – borrow one day, repay the next day
4. irrevocable (LOC) – writing institution guarantees funds are available to redeem the
Short term borrowing: short term notes such as: BANs. TANs, RANs
Long term credit services:
1. underwriting bond issues
2. purchasing new debt issues
3. fiscal services such as registration and transfer
4. granting of long term loans
5. long term leases
In cases of revolving bonds, banks are legally precluded from underwriting securities.
Long term credits should be handled through separate contracts.
Paying for Bank Services: two methods: compensating balance or direct charges for
services rendered – most govt units use compensating balance. In bidding for bank
services, the time deposit reserve requirement of 3% should be used to reduce the
Evaluating Bank Credit: The Glass Steagall act was enacted in 1933 - prohibited
paying interest on demand deposits, eliminated investment banking activities and
established the FDIC – this Act and the Securities Exchange Act were responsible for
stabilizing the banking industry.
A loophole in the fed reg may provide addt’l $100k insurance – FDIC has two unique
powers: divided into two entities as the receiver and a corporation. As receiver, will
marhsall the assets of the failed bank; as a corporation, will become the ultimate
purchaser of the failed bank. Two methods used by FDIC for disposing a failed bank:
purchase and assumption – less disruptive and less expensive.
Three reasons for not preferring the deposit pay off method:
1. avoidance of negative cash flow in the year of failure
2. reluctance of FDIC to face political consequences
3. payoffs increase the chance of disrupting public’s confidence
Collateral: govt units should use all three prevention tools:
1. FDIC insurance
2. credit evaluation
To avoid incurring a loss, govt units are encouraged to price their collateral at market
value before applying a percentage margin as compensation for less marketability and
liquidity – these margins are referred to as haircut.
Rating of financial institution: bank is assigned a uniform composite rating based on
evaluations of relevant financial and operational standards, criteria and principles –
examiner uses five key performance dimensions: CAMEL – capital, assets, management,
earnings and liquidity. Composite ratings are extremely confidential, know only to the
bank’s board of directors, key management officers and independent auditors.
Capital – the lower the capital base relative to the bank’s operations, the greater the risk
Assets – quality of the loans
Management – ability to deal w/ competitive pressures – dark side criminal misconduct
Earnings – most impt factor is management’s ability to control expenses, esp.
Liquidity – provides the margin w/ w/c a bank can meet loan demands and withdrawals
from customer deposits.
At a minimum, bank should provide govt units the ff:
1. auditors’ opinion
2. balance sheet
3. income statement
4. statement of changes in financial position
5. notes to financial statements
a. primary (common stock) capital to total assets 5.5%
b. total capital to total assets 6.0%
Total assets include all assets minus goodwill. Bank holding companies for the present
time, will include goodwill.
Nonperforming loans are loans that are more than 90 days delinquent.
Highly profitable banks will only have 50% in gross loans to total assets ratio.
The higher the dividend, the faster the capital will ultimately be depleted.
Each bank’s capital s/b based on the volume, type and character of the business being
Broker – brings buyers and sellers together for a commission – do not take position in
the assets being exchanged.
Dealer – makes markets in money market instr. by quoting bid and asked prices at w/c
they are prepared to buy and sell.
Primary dealer – makes market in govt sec and has met certain minimum financial
criteria set by NY Fed – required to maintain 125% adequacy ratio of liquid cap to
Secondary dealer – makes their markets in agencies or zero coupon bonds w/c would
not qualify them for primary status.
Govt do business with financial inst., asset mngmt group and investment advisers.
Asset management group – gen affiliated with broker/dealers – manage funds for
investors thru proprietary products like mutual funds – commonly used for pension fund
Investment advisers – offer inv advice for a fee.
Each of the above is regulated differently:
SEC applies to all reg securities broker dealers.
Bank dealers reviewed by bank regulatory authorities.
Primary dealers are monitored by NY Fed.
Unless they are financial inst. brokers/dealers are required to register with SEC and join
NASD – responsible for the operation and regulation of the over the counter securities
business and for financial operational regulations of member org.
Financial inst. are regulated by the FDIC, Off. of the Comptroller of Currency, the Fed
GFOA recommended practices (cash management):
“Collateralization of public deposits thru pledging of appropriate sec. by depositories is
the only way to fully guarantee the safety of such deposits.”
Federal law imposes certain limitations on collateral agreements. Fed law provides that a
depositor’s sec. agreement, w/c tends to diminish or defeat the interest of the FDIC shall
not be valid unless:
1. in writing
2. executed by the dep. inst. contemporaneously with the acq. of the asset
3. approved by the board of directors
4. has been an official record of the dep. inst.
Repo agreements – sales by a bank or dealer of a govt sec. with the simultaneous
agreement to repurchase the sec. on a later date. – tend to trade off fed funds rate -
legally, repos are secured transactions. – contractual transaction bet an investor and
issuing financial inst – most are written using US govt securities for collateral – collateral
is the repo’s underlying security – repo collateral should exceed the value of the original
inv plus acc interest – such overcollateralization is called a haircut – collateral s/b
adjusted in acctg records daily in response to market value changes
Master repo agreement – protects the investor by eliminating the uncertainty as to the
ownership of collateral and allows investors to liquidate collateral if a financial inst or
dealer defaults during the term of the engagement – all repo agreement transactions s/b be
preceded by a master repo agreement bet the govt and fin inst
Leveraging – using reverse repo to enhance portfolio returns – the cash obtained can be
invested in higher yielding instr
During periods of monetary contraction, repo rates tend to peak; tend to weaken during
Warning sign – if a dealer’s offering of rate exceed the rest of the market.
No magic formula for haircut ratios – s/b revised periodically depending on the volatility
of the instruments used for collateral – marking to market is recommended
Types of repo:
1. term repo – written for a specific time period of more than one day
2. overnight – written for one day
3. open – w/o specific maturity
4. tri-party – occur when a third party or custodian becomes a direct participant in the
repo transaction – rates on tri party repos are lower than rates on repos w/o collateral
delivery b/c there is less risk involved
Reverse repo (investor owns securities) – bank or dealer purchases under an agreement
to sell back to the investor on a spec. date at an agreed upon interest rate. Two uses:
avoid liquidating a portfolio to meet unexpected cash flow needs and to enhance portfolio
returns thru the purchase of sec. financed thru repo transactions. Should not be invested
in sec. whose maturity does not match the term of the reverse repo. Make sure legally
sanctioned before using reverse repos. – congress amended the code to exclude reverse
repos for the automatic stay provision w/c in turn allow lenders (investors) to liquidate
any repos in their position
Securities dealers like to reserve the right to substitute collateral –the investor is not
obligated to accept substitution unless the repo agreement so provides.
Derivatives – created from or whose value depends on (is derived from) the value of one
or more underlying assets. Certain derivatives may not be app. for all govt investors.
State and local govt may use derivatives.
Determine value of all sec. at least on a qtrly. basis – report in writing – include market
value, book value, and unrealized gains or loss.
Marking to market – practice of determining the market value of all securities in a
portfolio on a periodic basis – s/b done on qtrly basis for individual govt portfolio and at
least monthly for investment pools.
Volatility ratings (degree of fluctuations in price and valuation of securities) currently
are not mandatory.
Credit risk analysis alone is not sufficient to safeguard against the assumption of other
Short sale – the sale of a sec. not presently owned by the seller in order to take adv. of an
expected lower market price.
Split of proceeds – the degree of risk assumed by the lending agent
Lending agent credit risk, lending agent default risk and collateral reinvestment risk are
undertaken by the inst. client.
There is no limit in investments in US Treasury securities.
Weighted average maturity – the average maturity or reset period of all sec. that comprise
a portfolio. – govt should adopt limitations from 90 days to 3 yrs.
The longer the maturity horizon, the greater the price volatility.
Unless matched to a specific cash req. govt should not directly invest in sec.
maturing more than five years from date of purchase.
Govt should periodically initiate competitive bidding for major banking services.
Sweeps - balances from all of the govts accounts into one account – s/b considered for
operational (checking) acct to maximize inv earnings
CD – bears a specified dollar amount of dep, specified maturity date and specified
interest rate – maybe negotiable or nonnegotiable – only negotiable CD’s are truly
market instruments – no way to collateralize negotiable CD at this time – issued by
commercial banks; some by savings and loans….most S&L instruments are
Negotiable CD’s – issued by large financial inst; to assess risk, obtain credit rating on the
Non-negotiable CD’s – generally issued by local firms – carry penalties for early
redemptions – least liquid
Brokered CD’s – caution s/b exercised if the issuer is federally insured.
Bankers’ acceptances – created from a letter of credit issued in a foreign trade
transaction. – usually mature 30-180 days – prime acceptances are those w/ shorter
maturities that are eligible for discounting w/ the Fed Res – not very popular anymore b/c
of CP and Euro commercial paper – BA’s have not experienced principal loss – triple
Eligible BA’s are less costly than ineligible BA’s b/c they are not subject to reserve
Commercial paper – primarily used by corp to finance receivables, short term unsecured
promissory note issued for a maturity specified by the purchaser – most sold on discount
basis – exempt from registration with SEC – issued at money market rates so able to
obtain funds at a cost below the prime rate of the bank – mostly issued at discount rate
altho some may be interest bearing – maturities no longer than 270 days.
BA’s and CP’s are money market instruments.
Money market – defined as the markets where short term debt instruments are traded.
Most impt factor influencing creditworthiness of CP issuers is the nature of the
underlying bank line of credit.
Money Market Mutual Funds: Regulated by SEC – carry no federal guarantees but are
generally safe way to invest short term cash – differ from LGIP – should not be confused
with money market accounts (MMA) offered by fin inst w/c are accounts that pay interest
rates set by the bank and are federally insured – SEC requires that 95% of MMMF’s
portfolio consists of govt sec or money market inst rated A-1/P-1 by national rating
agencies… per SEC rule 2a-7 not to exceed 90 days and no one security exceed 397 days
Mutual funds are not eligible for deposit insurance even if the funds are available thru a
State Inv Pool – operate like a money market mutual fund for exclusive use of govt
GICs – uninsured, non guaranteed obligations of insurance co – typically pay higher
interest than comparable bank deposits – used primarily in pension funds
LGIP – operate independent of the state govt – authorization is derived from state
statutes that allow govt to perform collectively any service or adm function that they may
undertake individually – known as joint powers agreements – not required to register w/
SEC b/c they fall under the govt exclusion – while this exemption allows greater
flexibility, it also reduces investor protection
- measure that allows investors to compare their portfolio performance with that of a
similar standard portfolio.
- there is no universally accepted benchmark for short term public sector portfolio
(commonly used include yields for 90-day US Treasuries)
- by developing a composite benchmark made up of allowable investment instruments,
the benchmark is already adjusted for credit risk and interest rate risk
Reasons for hiring investment advisers: (should be governed by written agreements)
1. enhance investment yields – adviser w/b be able to earn higher rate of return – may be
diff if govt has restrictive inv policy
2. increase safety of inv portfolio
4. enhance credit quality of portfolio
5. economies of scale
6. enhanced internal controls – segregation of duties
7. access to credit research
8. access to capital markets that govt don’t have access
9. expertise on specific sectors of the market
Government officials cannot delegate responsibility for the portfolio to the adviser –
MUST remain actively involved in the process.
Recommended practice in hiring investment advisers:
1. use delivery versus payment procedures w/ third party custodians
2. prohibit against self dealing audits
3. timely reconciliation
Investment advisers may also act as broker/dealers. Caution: when investment adviser
is also broker/dealer, the investment advice may not be an objective opinion
Advantages of discretionary authority (granting an adviser complete authority to execute
inv trans sub to general constraints by govt) given to advisers: quicker response time to
market opp; disadvantage = loss of control over funds and decision making process
Disadvantage of nondiscretionary - staff time tied up and diff to determine performance
All inv advisers are required to register with SEC unless activities qualify for exemption
– examples are bank trust dept and brokerage firms who offer inv advise in conjunction
with offering sec (these are regulated by fed or state agencies). Any non-bank adviser
generally s/b registered.
To mitigate risks of discretionary arrangement, should have written inv policy and
written advisory agreement.
Services provided by investment advisers:
- manage the portfolio
- fundamental and technical market research
- assist in dev and implementing investment strategies
Steps to selecting an investment adviser:
1. write out inv goals and obj
2. prepare questionaire
3. send RFP
4. compile data
5. analyze data
6. interview selected candidates
7. analyze the above
8. select an adviser that most closely meets the jurisdiction’s needs
Portfolio managers should review the govt account at least weekly.
Past performance is not a guarantee for future performance.
Cutting portfolio into smaller portions could result in higher fees and diff in record
Fee should not be the primary factor in selecting adviser.
Some impt elements of inv advisory agreement:
- s/b specific to the service being provided
- adviser must officially accept appointment
- adviser is a professional – and should be held to the “prudent expert” rule (if prudent
person rule is cited, should state that the standard of care shall be in no case less
stringent than any other inv standards)
- provision to terminate immediately under adverse conditions
Evaluating adviser’s performance:
- if adviser has added value to the portfolio in terms of performance and credit quality
- adviser able to explain how they beat the index (standard benchmarks for short to
intermediate term inv portfolio include yields of 90-day tbill)
- performance s/b reviewed over 3 to 5 yr cycle
- summary of portfolio holdings – list of all securities
- performance – total returns for the period
- maturity/duration indicators – help monitor interest rate risk
- transaction summary – provide investors with transaction confirmations
- mark to market – show cost and market value
- primary manager has left
- investment strategy has changed
- not doing what was promised
- firm is outperforming the market
FACTORS THAT INFLUENCE INTEREST RATES:
Interest rate – price of funds borrowed and lent in various money markets – determined
by the interplay between supply of funds provided by investors and the demand for funds
needed by borrowers. When rates are high, borrowers demand fewer funds b/c the cost is
high – tend to parallel economic cycle.
Besides the business cycle, interest rates are also affected by Fed Reserve Board’s
monetary policy and international economics.
Extended periods of low interest rates provide expansionary incentives for businesses and
Even experts disagree on where rates and the economy may be headed.
Sophisticated economic analysis may be unnecessary for govt constrained to have
investments matures less than two years.
Flow of funds: model breaks the economy into 3 or 4 primary sectors:
1. household – tend to increase borrowing during periods of economic expansion as
sustained employment fosters consumer confidence
2. businesses – expanding economy stimulates credit demand to finance additional
plants and modernize facilities
3. governments – borrow to fund budget deficits
Note: In the federal sector, fiscal policy is ordinarily countercyclical: recessions result
in increased federal demand for funds as tax revenues weaken in the face of surging
social insurance and other entitlement programs; on the other hand, a growing economy
stimulates tax receipts and usually moderates federal exp growth as welfare subsidies are
eliminated. In the state and local level, fiscal deficits and surpluses historically have
followed the business cycle. Governmental fiscal policy can affect interest rates in ways
that go beyond simple budgetary impact.
4. international economic entities – foreign investment in American securities provide a
net inflow of funds; a shift out of dollar assets into financial securities in other
countries might force a net outflow of funds.
Capital outflows usually reduce the supply of credit, thereby forcing higher interest rates
There is a close relationship bet the different economic sectors and the financial
instruments used to borrow funds. Household borrow thru mortages and consumer
credit; businesses typically use corporate bonds and commercial paper and fed govt uses
US govt sec and state/local use municipal (tax exempt) securities.
Many sectors of the general economy are subj to cyclical fluctuations of recession and
recovery that exert predictable pressures on interest rate levels. Only the govt sector
tends to increase credit demands during recessions. These countercyclical effects
partially offset the private sector but seldom match the power or private economic forces
in a capitalist system.
Interest rates tend to stay relatively low in the initial stages of recovery b/c excess
capacity exists and price levels remain moderate.
3 statistical series of economic activity:
1. index of coincident indicators – measures general business activity - tends to rise
during economic expansions and fall during recessions
2. leading economic indicators – employs statistical indicators that over previous
business cycles, have tended to indicate future shifts in economic activity – predictive
power – correlation bet leading indicators and economic events
3. index of leading indicators – consists of ten time series indicators selected for their
economic significance, statistical accuracy, timing, conformity to the business cycles
Four distinct economic forces:
1. labor market – work week is leading indicator
2. capital investment – bldg permits and contracts for nondefense capital goods
3. inventory investment – represents future retail demand; vendor delivery times and
4. financial flows – measures the economic reliquefaction that precedes the next
Yield curve – relationship bet short term and long term interest rates; a graphic
presentation of the relationship bet interest rates and the maturity of a specific fixed
income security – depicts the difference or similarities among the market yields for
identical securities with longer or short maturities – represents an equilibrium between
the supply and demand for credit of different maturities.
On CD’s, rates are typically quoted accdg to maturity.
Common types of yield curves:
1. flat yield curve – most often arise when interest rates are above historical norm – b/c
longer maturities carry greater risks, the flat yield curve typically allows long term
investors to capture potential capital gains w/o sacrificing yield, assuming interest
rates subsequently decline and bond price increase.
2. positive or upward sloping curve – market wherein long term rates are higher than
short term rates – b/c investors prefer liquidity, they are willing to accept a lower
yield for short term instruments – also reflects the expectations that interest rates will
increase in the future: an ascending yield curve often represents a surplus of cash
available for short term investments --liquidity preference – the aversion to long
term market risks and desire for short term securities
3. negative downward sloping or inverted yield curve – yields on short term
securities exceed returns on long term instruments
4. humped yield curve – short term and long term markets clear at lower rates of
interest – suggests a shortage of capital available to the intermediate term section –
could precede a peak in the business cycle
Yield curve analysis begins w/ the supply and demand of funds payable at a future date.
The expectations theory of interest rates suggests that investors’ current expectations of
future interest rates dictate the shape of the yield curve. The premise that today’s long
term interest rates are determined by investors’ expectations of future short term interest
- if interest rates are expected to increase, the yield curve must have positive slope –
long term maturities must yield a higher return to compensate for the expected
increase in short term rate
1. when investors leave the bond market yields rise
2. when investors jump from long to short term maturities, long term yields rise while
short term yields decline
3. when investors are back into bonds, yield curve flattens
In essence, those who leave the market take their money and run, leaving remaining
investors w/ sec having higher yields but w/ lower prices – b/c long term bonds must drop
farther in price to produce the same yield.
1. participants in the money market should shorten maturities in a rising yield (falling
prices) market esp in the early stages
2. market investors should lengthen maturities in a falling yield (rising price) market
Interest rates rarely increase or decrease simultaneously across all market
Cash managers have two choices for basic investment strategy:
1. automatic pilot approach – simply invest funds for the maximum maturity possible
under the cash budget, ignoring interest rates differentials
2. active managers may pick from the smorgasbord of interest rates available – requires
analysis and relationship bet short term and longer term yields for comparable sec
Yield curve investment rule:
1. if projected rate is lower than expected, stay short and try to roll over at a higher rate
2. if projected exceeds expectations, go long
The final balancing factor in the supply and demand equation embodied in the money
markets is the deliberate intervention by the nation’s central bank, the Fed Res sys.
In the United States, the monetary sys is based on a network of financial inst channeling
funds thru commercial banks.
The depositors’ accts constitute the foundation of the money stock or money supply. In
fact, the currency printed by the US Treas is far less significant than depository acct
Under the so-called fractional reserve sys, the nation’s money supply will increase every
time addtl dollars are released from the required reserve acct and become available for
lending by a financial inst.
By act of congress, responsibility for monitoring the total money stock is delegated to the
Fed Res sys – w/c consists of a network of 12 quasi independent reserve banks operating
regionally throughout the states.
The primary mechanism for effecting an increase in the money supply is to purchase or
sell US Treas sec in the open market.
In actual practice, many open market transactions of the Fed are accomplished thru repo
and reverse repo, rather than outright securities sale. This practice eliminates the
physical exchange of sec and allow the Fed to enter the market on a short term basis to
accomplish other goals and control money stock.
The basic bldg block of monetary aggregates is know as MI – represents all transaction
balances and is based statistically on all privately held currency plus demand deposits.
The immediate effects of the Fed’s open market operations:
When the Fed buys: When the Fed sells:
- inject reserves into the banking sys drains reserves from the banking sys
- increases the money supply decreases the money supply
- increases the demand for govt increases the supply of govt sec in the
securities in the secondary market secondary market
- increases the price of govt sec decreases the price of govt sec
- decreases short term interest rate increases short term interest rate
THE MARKETS – cash, futures and options
The average public sector cash manager never participates directly in most of the
financial markets – instead, concentrates on the cash markets for short term sec, the
so called money markets where trades are made for the immediate sale or purchase of a
In the cash marketplace, most transactions are conducted on a cash basis – w/ payment
and delivery accomplished on a same day basis.
In addition to the cash markets, there are markets for related financial instruments.
Technical trading systems driven by futures market prices and speculators’ actions
sometimes cause distorted price movements in the cash marketplace.
Options market – buyers and sellers deal not w/ credit instr but w/ the right to purchase or
sell various sec at particular prices on or before certain dates.
Most money market instruments are priced against the nearest maturity in the govt sec
Four major sectors of govt securities market:
1. US Treasury – concerned primarily w/ the sell side of the market
2. Fed Res System – influences markets thru it open market operations, by virtue of its
monetary policy role
3. investors – net providers of cash – so long as US Treas engages in deficit finance
thru issuance of addtl debt
4. govt securities dealers – primary, regulated (SEC), nonregulated, commercial banks
1. Commercial banks and other depository institutions, regularly purchase govt sec as
part of their secondary reserve operations.
2. Insurance companies – longer term to finance annuities
4. mutual funds - most impt are the money market funds w/c are sensitive to short term
5. cash managers – in private sector, cash managers, prefer to deal w/ non govt sec to
obtain addtl yield; in govt sector, opposite preferences
6. securities dealers
The govt securities marketplace is the benchmark for all other money market instruments.
ESTABLISHING INVESTMENT OUTLOOK
In the context of a written inv policy and active monitoring of the inv officer’s actions, a
formalized investment outlook may help to improve communications and accountability
– outlook may include long term, macroeconomic, cyclical and short term operations.
Long wave economic cycle – altho the central bank intervention and federal fiscal policy
can influence and shape private decisions, the capitalist economy is dominated by
simultaneous disjointed and multiple decisions made at competing levels by various
Public investment officials (with portfolio balances exceeding $10 million) should
periodically formalize their investment outlook, even if conducted at a rudimentary level.
Structured outlook concepts:
- identify major forces and factors likely to influence market
- record present dev, status or trend
- identify expected future scenarios and the investment implications
- identify factors that signal a change in the trend and the need to reconsider the
Alternative would be to maintain a passive management approach which has advantages
TECHNICAL APPROACHES TO SHORT TERM INVESTING
Fundamental analysis – economic approach to market analysis, purpose of which is to
detect likely future changes in the forces that underlie the interest rate structure – forces
that affect the supply and demand of credit
Technical analysis – internally oriented – market behavior study – most widely accepted
form of technical analysis is the use of moving averages to detect trends and turning
Moving averages have two special properties: first, smooth out price fluctuations;
second, help ascertain the existence of a trend. Some analysts maintain that a trend is
intact as long as the moving average does not decline for more than two or three days.
SHORT TERM INVESTMENT STRATEGIES
Investment of funds, even short term funds, requires acceptance of certain risks including
credit and market risks. Also, a liquidity problem may also arise b/c the investment
officer misjudged cash disbursements requirements thru aggressive or over optimistic
cash forecast; counterparties fail to correctly wire funds or b/c of other mechanical
The liquidity buffer may not be treated as a separate fund; rather s/b viewed as
Tbills – as book entry securities, there s/b no question of the entity’s ownership so the
insolvency of a bank or a dealer should not interfere w/ liquidation – for this reason,
prudent investors seek to insure that ownership of the Tbills is reported in their names as
customer and held in safekeeping by an independent third party custodian, whenever
SEC Rule 2A-7: imposes a 90-day weighted average maturity limit on the portfolio and
requires that at least 95% of the investments held in the portfolio must be rated in Tier 1
(the highest of credit quality) and that no more than 1% may be in the second tier.
Applies to all money market mutual funds and mandates such funds to maintain certain
standards including 13 mo maturity limit.
The simplest of all passive investment management strategy is to let someone else do it –
e.g., state pools, purchase of MMMF w/ short term maturities and use of inv advisers.
In a normal yield curve environment, in w/c the market compensates investors of longer
term fund thru superior yields, short term inv in a money market fund or short term state
pool may prove inferior.
Laddered maturities: offer several advantages – b/c market rates of interest fluctuate over
time, laddered portfolio assures that investors receive in the long run an average rate of
return. Even w/ laddered maturities, investors should maintain a liquidity buffer.
To some extent, the concept of active management represents a fallacy b/c the
average investor does not outperform the market.
FIXED INCOME INVESTMENTS
For investors of funds w/ longer horizon or holding period, fixed income securities
(bonds) represent an increasingly important portion of the portfolio and strategy. The
general driving concept is that prudent investors rarely acquire fixed income sec that they
cannot afford to hold until maturity.
Acquisition of fixed income sec for longer term limited to:
1. debt service funds including refundings
2. special assessment district prepayments
3. cap proj fd – match planned exp
4. certain trust funds
5. pension fund assets
6. pooled inv portfolio assets subj to gov body approval
7. other special circumstances w/c are suitable
The inv policy should specify what funds and assets are suitable inv for long term instr.
By extending maturities, funds are locked up for prolonged time periods and market risks
increase. Longer term instr are becoming more attractive b/c of results from a bond’s
increasing mathematical volatility as maturities lengthen = the price change necessary to
compensate for a given change in interest rates is a function of maturity so capital gains
are greatest when long term bonds rally as a result of declining interest rates.
Only a fragment of a bond’s total return is rec’d directly from coupons and principal
repayment – most of the ultimate investment income is received from interest earned on
the inv of coupon as it is paid.
The key factor affecting the total return of bond inv is the rate of future reinvestment.
For investors who do not reinvest interest income but use coupon interest for current
expenses or other purposes, the interest on interest concept may not be appropriate.
If future interest rates fall lower than the levels of the long bonds coupons for the callable
Treasury bond outstanding, it is assumed that the Treasury would exercise its call feature.
During most periods of an economic cycle, the diff bet call date and original maturity
date are not terribly significant b/c market changes are minimal for a bond trading above
or below par throughout the cycle.
Rate of return – amount of income rec’d from an investment expressed as a percentage
of its price.
Market rate of return – yield that an investor can expect to receive in the current
interest rate environment utilizing a buy and hold investment strategy.
Total return – interest income plus capital gains (or minus in losses) on an inv and is the
most important measure of performance – price app + dividends paid + capital gains
Maturity – on a fixed income sec is the date that principal will be repaid.
Reinvestment risk – that a fixed income investor will be unable to reinvest income
proceeds from a security holding at the same rate of return currently generated by that
Cold calls – situations where investors did not know the investment rep or did business
with unfamiliar firm.
Key to managing broker/dealer relation is to distinguish the competent professional with
sound reputable firms from the incompetent and unscrupulous.
Broker – who brings buyers and sellers together for a commission – does not take
position in the assets being exchanged.
Dealer – makes money in money market instrument by quoting bid and asked prices.
Primary dealer – makes a market in got securities and met some financial criteria by
Secondary dealer – make their markets in agencies or zero coupon bonds.
Services provided by b/d:
1. access to markets – major function – size of purchase may preclude investor from
acquiring an instrument directly from the issuer
2. market analysis – follow economic activity
3. portfolio analysis – advice on how to structure portfolio to meet inv obj
4. credit research/securities analysis – credit research on obligations such as CP’s and
5. relative value analysis – inv options from many financial sectors – see below
Got officials have less access to the money markets than broker/dealer – broker/dealer do
Relative value analysis – tools that allows investors to systematically compare
alternative securities – based on mathematical principles and historical data (at least one
year) and subjective evaluation.
T-bills are quoted on a discount basis.
CD’s are quoted on a 360-day basis.
Investor must ask for info on securities such as price, structure and historical spread
relationships before buying securities.
Disadvantages of using broker/dealers:
1. costs – compensated by profits generated from trades; spread narrow on Treasuries
but wider on other instruments.
2. Some services offered may be unnecessary – limited benefit.
3. Potential for abuse – one of the signs of risky investment is the spread between the
bid and asked price – the wider the spread, the greater the risk.
Churning – fraudulent practice – broker/dealer engages in excessive number of or
frequent transactions to generate commission.
Caution – broker/dealer’s legal staff may be reluctant to sign a certification – crucial that
broker/dealers receive, read and understand the entity’s investment policy.
1. identify general areas of inquiry
2. discuss firm’s policies, procedures and financial position
3. know the broker/dealer and the firm
4. thoroughly investigate the financial condition and reputation – investors can examine
publicly available financial data and annual reports
Money market mutual funds must submit semiannual reports to the SEC.
NY Fed requires 125% ratio for measured risk as standard for capital adequacy.
3 forms of certification from dealers:
1. will adhere on a continuous basis to capital adequacy standard
2. audited financial statement in compliance with the standard
3. letter from the CPA – no material weakness in internal system and controls
While designation as a primary dealer may ensure financial stability of the firm, the
designation does not ensure that the individual broker/dealer is familiar with public sector
A brokerage firm should assure public official that all of its officers and employees
offering investments to the public entity are trained in the precautions appropriate to
public investing. Require at least four public sector references – should be selected on
the basis of ethics and investment philosophy – thru competitive bidding procedures.
Rules that help to ensure broker/dealer to comply with investment policy:
1. avoid broker/dealer that push exotic securities
2. be wary of fantastic yields
3. establish a long-term relationship
4. insist on state registration
5. find broker/dealers w/special expertise
Send ff info to broker/dealer:
1. investment policy and procedures
2. most recent investment portfolio report
3. recent financial statement
In the event a got does not obtain competitive bids, should obtain written doc of price
markups prior to completing transaction.
To monitor broker/dealer – primary consideration s/b given to the evaluation of
comparative pricing, the frequency of failed transactions and compliance w/the
procedural investment guidelines.
Require broker/dealer to sign a form stating that they have received a copy of the inv
Evaluate broker/dealer relationships at least annually.
A broker/dealer that consistently loses in a competitive bid situation s/b dropped from the
If something goes wrong in the b/d relationship, public investors have some remedies
Got securities market is basically a telephone market – got entities request that all
telephone conversations be recorded to help prevent abuse or misrepresentation.
SEC does not have the administrative remedies available that the self-regulatory org
NASD rules of fair practice deal with issues such as price markups, suitability of
recommendations to customers, client accounts and record keeping, disclosure
requirements and rules about advertising and sales literature.
Good b/d relationship:
1. reputation of b/d and the firm
2. competitive pricing
3. overall god service
CASH MANAGEMENT – the practice of maximizing the income of the organization’s
GFOA recommends that the entity’s cash management portfolio shall be designed with
the objective of regularly exceeding the average return on 3-month US Treasury T-bills,
the state investment pool, a money market mutual fund or the average rate on Fed funds,
whichever is higher.
Funds held for future cap proj s/b invested in sec that reasonably can be expected to
produce enough income to offset inflationary construction cost increases.
Objectives of cash management:
1. support got operations – not the other way around
2. meet legal obligations
3. protect gov assets – see below
4. provide adequate liquidity – time inv so that they mature at the same time they are
needed to meet obligations – allow a margin for unexpected exp
5. be accountable – has gone beyond simple cash acctg – now expected to be able to doc
compliance with all state laws and local policies – report and explain inv earnings.
The overriding goals of cash management are:
1. maximize availability – decrease time lag from the earning of rev to its cash
conversion and timing exp to be made on its due dates.
2. maximize yield – max yield on cash bet its collection and disbursement.
Protecting got assets:
1. default risk – applies mainly to investments – issuer will be unable or unwilling to
redeem an investment
2. market risk – changes in the financial markets reduce the value of the inv
3. reputational risk – got will lose stature by making a cash management mistake
4. safekeeping risk – occurs any time that cash or investment assets are being held or
5. collection risk – significant difference bet revenue earned and revenue collected
Revenue collection – primary driver in determining how much cash is available for inv
Payroll/payables acctg – when cash must be on hand to meet obl
Purchasing – can provide valuable advance info on exp – others are data processing and
legal counsel – info must also flow both ways bet budgeting and cash management
Cash management operates in an arena that is dominated by the federal govt.
Cash management – cyclical in nature:
1. systems cycle – consists of occasional policy and contractual decisions by cash
2. operating cycle – comprises the monthly, daily, even hourly actions taken to operate
5 elements in systems cycle:
1. evaluating needs
2. establishing policies – most common is investment policy
3. establishing annual objectives – should cover availability; yield; dollar return; prog
4. establishing relationship w/financial inst – all got should recognize that there is a
political element involved regardless of the selection process – selecting w/b is
usually less formal than selecting banks b/c most got maintain relationships
w/multiple dealers and b/c investments are generally short-term compared to full
5. establishing acctg sys – impt are cash acctg sys; investment tracking sys; receivables
sys; and payables sys
6 major steps in operating cycle:
1. forecasting cash flows – identify rev and exp streams over a given period in the future
(usually six months to one year)
2. collecting revenues – received in a timely manner, credited to proper fund and
deposited to correct bank acct as quickly as possible – should limit the number of
offices that collect and deposit revenues
3. making investments – most complex and risky step
4. tracking investments – track all o/s inv; amount, yield, maturity, source of funds
5. making disbursements – consider not only amt and date of pymt but also
6. monitoring/evaluating/auditing – must be done on a daily basis
The Tax Reform Act requires got to track earnings on bond proceeds.
3 obj of cash control and reporting systems:
1. assure timely recording of cash receipts and disbursements
2. assure sufficient funds available to meet operation and cap exp needs
3. facilitate investment of idle cash to max rev
2 methods of interest allocation of federal monies:
1. average daily cash balance by fund
2. assure sufficient funds available to meet operation and cap exp needs
3 categories of disclosure requirements for deposits and investment:
1. legal and contractual provisions – include maturity, collateralization and how
collateral is held – when authorized investments are not addressed in legal or
contractual documents, the govt’s investment policy should serve as a basis for this
2. balanced sheet data
3. activity information
One of the most common compliance errors involving this standard is the
misclassification of certain deposits as investment. As a general rule, if an instrument is
subject to state or federal depository insurance, it should be classified as a deposit.
A common non-compliance disclosure related to deposits occurs when collateral levels do
not meet legal requirements.
GASB divides credit risk into three categories:
1. risk associated w/issuer of a security
2. risk associated w/a financial institution holding deposit
3. risk associated with the custodian of securities or collateral
3 categories credit risk of total bank balance:
1. insured or collateralized w/securities held by the entity or by its agent in the entity’s
2. collateralized w/securities held by the pledging financial institution’s trust dept or
agent in the entity’s name
All parties have agreed that the bank balance generally is not equal to the carrying value
3 categories of investment credit risk – disclosing market value and carrying value:
1. insured or registered or securities held by the entity or its agent in the entity’s name
2. uninsured or unregistered w/securities held by the counterparty’s trust dept or agent in
the entity’s name
3. uninsured or unregistered w/securities held by the counterparty or by its trust dept or
agent but not in the entity’s name
FDIC insurance generally is $100K – addt’l coverage may be available in certain
circumstances – the possession of separate fed tax ID provides evidence that the officials
are truly separate custodians – also deposits held in trust.
Trust dept – limited to trust dept of financial inst when used in context of deposits and
investments. GASB believes that a greater credit risk s/b disclosed for investments held
in the entity’s name by a broker/dealer trust dept.
A safekeeping dept is not considered legally separate from the financial institution –
therefore securities held would be category 3.
Agent – a financial inst or b/d that has a contractual relationship w/the got to hold, at the
discretion of the got, securities owned by or pledged to the govt.
Although the third party may in effect be an agent for the financial inst., the
presence of a third party agreement does not prevent the third party from acting as
an agent for the got in this transaction.
When the financial institution places an order for sec or uses sec from its own portfolio to
fill the govt’s order, the financial inst s/b classified as a counterparty – s/b noted that
acting as a counterparty of certain transactions does not jeopardize the financial inst’s
agent classification for the remaining sec held for the govt.
GASB 3 focuses primarily on disclosure requirements – also provides display guidance.
GASB divides repos into 3 categories:
1. standard – plain or plain vanilla – govt tsfrs cash to b/d or financial inst; the b/d or
financial inst tsfr sec to govt and promises to repay the cash plus interest in exchange
for the return of the same sec
2. fixed-coupon – same as above except the returned sec have the same stated interest
rate as, and maturities similar to, the sec transferred
3. yield-maintenance – same as above except the sec returned provide the b/d or fin inst
with a yield specified in the agreement.
1987 codification provides: income from repo and fixed coupon repo shall be shown
as interest income; therefore the effects on govt’s fin statements generally is to
reclassify cash to investments – whereas, yield maintenance repos should be
accounted for as purchases and sales of securities.
Also, reverse repo should not be netted – sec tsfrd under reverse repo and fixed
coupon reverse repo s/b reported as obligations and the underlying securities s/b
presented as investments – also interest cost associated w/the reverse repo s/b
reported as exp and not netted against interest earnings.
When applying GASB standard, got should not let the status of categorization of their
investment dictate their overall investment policy.
COLLECTION AND DISBURSEMENT:
Until such time that the govt’s bank account has investable cash, the checks deposited are
considered deposit float not investable cash – for investment purposes, checks and
receivables s/b deposited into a single account such as a concentration account.
Concentration accounts – are single accounts established at a commercial bank in
conjunction with one or more zero balance disbursement accounts – hold govt’s available
funds while a number of other accts containing zero balances are set up to handle the
4 types of collection:
1. collection driven by services provided
2. collection dictated by state or local law
3. immediate and unpredictable collection
4. federal or state grant receipts
These are not exclusive categories – not the only collections can be classified.
3 ways to bill recurring services:
1. prebilling before service delivery
2. billing upon service delivery
3. billing after service delivery
Traditional collection system: taxpayers to govt coll dept to bank to fed reserve sys
Improving collection procedures:
1. cycle billing – the peaks and valleys can be minimized and staff used more efficiently
2. other methods – early mailing of bills; increasing frequency of collection
3 forms govt receive revenues:
1. on site for payment of service delivery
2. checks received on site or thru the mail
3. wire transfer or other electronic methods, e.g., ACH
float – checks are credited to the govt acct before they clear the banking sys but are not
available for inv purposes until payment has been made by the payee’s bank.
Credits thru ACH – are funds available for immediate investment.
Improving deposit procedures:
reduce float in receivable
collect accurate acctg information
take adv of lock box processing
3 types of collection float:
1. mail – amt of time a payment remains in the mail sys
2. administrative – amt of time necessary to process check – totally under govt’s control
3. collection – amt of time necessary to credit a govt’s bank acct after check has been
ACH movement is significantly less than wire transfer movement because the originator
is creating the data file. In wire transfer, the originating bank is creating the data file
while the receiving bank is deciphering the data file into meaningful info for its
Vendor express – the primary mechanism for disbursing federal funds in the future.
Major goal of disbursement system – to slow the payment of funds so max amt is
available for investment but ensure the timely payment of bills.
Developing an efficient disbursement sys involves:
1. an analysis of disbursement patterns
2. efficient management of disbursements
3 components of disbursement float:
1. delivery float – time it takes to deliver check after it has been prepared
2. processing float – time for org to process receipts for deposit or invoice for payment
3. transit float – time it takes a check to clear the banking system
2 ways govt disburse funds:
1. commercial bank checks
2. wire transfer – costly, should not be used for small transactions
Difference between warrants and checks – funds are not automatically released when a
warrant is presented for payment – the payor is allowed a second chance to review the
transaction before payment is made.
Controlled disbursement can extend the time required for checks to clear a govt’s
Sharing the govt’s deposit with all or most banks in the community is the most common
arrangement – also the least desirable method – advantages are political – the
disadvantages are economic – nobody gains since none of the banks acquire sufficient
deposits to make the endeavor profitable and the govt does not earn sufficient interest to
offset the cost and inefficiencies encountered – rotating banks is preferable but not as
Banking arrangements should be the result of formal, written policies. Because
some banks have limits on available collateral, a max amount should be stated in the RFP
that will be used instead accdg to the specified interest rate provision – amounts over
that limit would be invested on “best efforts basis”.
Rate for repos – should be based on Fed Funds Market
Fed Funds Market – an electronic exchange between financial institution and brokers
where ints that have excess reserve balances can sell those balances to inst needing
reserves to meet their reserve requirement – are lent unsecured to other inst generally on
an overnight basis.
Govt – are unable to directly participate in the Fed Funds market because it is
limited to financial inst and brokers.
Effective Fed Funds rate – the average of all rates during the day, weighted for the
volume of trades occurring at each rate – generally higher than the average of the high
and low rate during the day – can be verified by subscribing to the weekly statistical
release by the Fed Reserve Board.
Although banks offer various types of investment services to govt units, it is widely
recommended that govt retain the investment responsibility for themselves. Shopping for
investment services should be separate from shopping for other bank services.
Govt generally likely to use money market instruments because of the liquidity and
Money market instruments – not a formal organized market like the stock market – an
informal telephone market operating for the most part, without any regulation –
comprises 36 or so primary govt sec dealers and very large banks – anyone else wanting
to participate must go through one of the primary govt sec dealers – come in diff sizes but
have a common denominator – that of being high quality, short-term debt instruments –
not all of these inst are legal investments in all states.
Line of Credit – enables a govt unit to borrow money from a bank at any time up; to a
Letters of Credit – most secure lines of credit, cost more than a normal credit line – not
cost effective to maintain if infrequently used – should have separate price in bank
Govt desiring to improve banking arrangements should carefully define their own needs
before initiating negotiations with the banking community.
Compensating balance – most popular form of paying for banking services because:
1. banks prefer to have deposits on hand rather than fees
2. compensating balances are non-budgeted items
3. easy to administer
In the absence of an RFP specification regarding the reserve requirement, the banks
will use 12%, w/c is the reserve requirement for demand deposit accounts. By
specifying, it will be 3%. Compensating balance in a repo agreement are not subject
to reserve requirement.
For govt that have an aggressive investment policy, the direct payment approach is
usually the best and least expensive method of paying for banking services.
Reasons for evaluating bank credit:
1. avoid any embarrassment that may come from keeping money in a bank that
subsequently is closed by the FDIC
2. protect assets in those states where there are no collateral laws concerning govt
2 methods of analyzing bank credits:
1. do it yourself – more complex to do but can be used if govt has appropriate staff
2. outside help
Besides bank failures, legislative and regulatory activities changed the nature of banking.
The Financial Inst Reform, Recovery and Enforcement Act (FIRREA) of 1989 specifies
the requirements that must be satisfied if an asset acquired by the receiver of a failed inst
is to be subject to the claims of a depositor based on a security agreement.
Fed law imposes certain limitations on collateral agreements – maybe able to avoid a
perfected security interest and leave the public depositor with only the right share with
other creditors in the pro rata distribution of the assets of the failed institution.
FDIC’s position: Any agreements w/c may exist outside the records maintained by that
inst would not be considered.
FDIC’s policy statement: both statutory and case law require that to be legally
enforceable, a perfected security interest must be in compliance with all aspects of the
law concerning the FDIC’s conservator rights, including the requirement that acquisition
of collateral be contemporaneously executed with a security agreement.
The contemporaneous issue was lifted for public deposits by the FDIC but govt must still
execute a perfected security agreement with each of its banks.
Govt have sought to ensure that in a financial crisis, the failure of banking inst would not
jeopardize the general health and safety of the population.
Typically, govt securities are pledged to protect public deposits.
Prudent risk control program include formal depository risk control, credit analysis and
use of fully secured investments. In the absence of an effective statewide collateral
program, local officials should establish and implement collateralization procedures.
1. creation of a statewide collateral pool by legislative action
2. general statewide requirements for full collateralization as a condition of doing
business with public entities – key advantage is that local treas need not become
involved in the administrative process of protecting their deposits
3. Statutory permission to implement depository coll on voluntary basis
Recommended collateralization practices:
1. Obtain copy of your state coll laws
2. Identify your depository risk exposure
3. Establish a written depository coll agreement
CASH FORECASTING – is the sum of the monthly rev and exp streams and the
beginning cash position – regardless of cash position, all govt can benefit from cash
Cash flow forecast – schedule of expected receipts and disbursements over a given time.
A formal cash budget provides tangible evidence of a tax exempt entity’s need to borrow
Main obj of each is to forecast cash position at some future point in time, each has diff
purpose, benefit and cost – use informal to sophisticated approach.
An accurate cash forecasting is an important cash tool b/c:
1. can improve investing earnings
2. can identify temporary cash deficits that require short-term debt financing
3. can ensure liquidity
4. can enhance creditworthiness
5. can warn of impending problems
1. annual – provide monthly estimates of cash position
2. monthly – provide weekly estimates of cash position
3. weekly – provides daily estimates of cash position
Since the passage of the Tax Reform Act of 1986, borrowing in the short-term for
the purpose of investing in higher yielding instr to obtain arbitrage has been
At least, cash forecast should be prepared on an annual basis with cash position estimated
monthly. How often done depends on: (choice left to the discretion of the individual
1. time and resources available
2. amount of funds under management
3. desire to improve the cash management program
4. need for accurate information regarding cash position
Factors to consider when deciding what type of forecast to prepare:
1. type of financial information available
2. time period to forecast
3. level of detail needed
Receipts and disbursements can be characterized as recurring or nonrecurring.
Advantages for consolidation of cash flow forecast: (assumes flexibility in interfund
borrowing to cover shortfall in individual funds)
1. often smoother than for individual funds
2. pooling of cash can lead to greater inv earnings
3 steps in forecasting receipts process: (should prepare a monthly schedule of prior
receipts and then calculate a simple three-year average)
1. review the annual fiscal budget
2. develop historical analysis of receipts
3. create forecast of monthly receipts
In order to accurately forecast receipts: gather info on current FY budget and monthly
financial reports from prior years.
A rule that cash forecasters often use is to evaluate only those sources that account for
15% or more of a govt’s total revenue – aggregate smaller items and forecast them as a
4 steps in disbursements forecasting:
1. evaluate annual fiscal budget
2. collaborate w/various depts on reports of projected expenditures by month
3. develop historical analysis of disbursements
4. create a disbursement forecast from info obtained
In order to accurately forecast disbursements: collect info re annual fiscal budget;
projected monthly exp; including cip; monthly financial reports for 3-5 years.
Adjustments to forecast should reflect actual results.
Unanticipated changes that affect cash flow and the cash forecast include:
1. changes in tax rate or base
2. changes in economy
3. changes in administrative procedures
4. one-time changes such as sale of an asset
5. unforeseen demand for govt services
DEVELOPING INVESTMENT POLICY:
No matter how small a govt entity might be, it should have a written inv policy. Rate of
return must never become the prime consideration in the investment of public funds.
Before undertaking the development of the policy, the writer must understand the laws
w/c govern inv activities. While state and local laws might restrain certain activities, they
often allow more latitude. The professionalism and availability of staff responsible for
inv prog should drive the inv policy process and the final determinant whether inv
strategies are active or passive. The tone and direction s/b set by the governing body.
Steps in developing inv pol:
1. meet w/top mgmt
2. involve elected officials
3. study what other govt had done – while it is a good idea to see what else has been
done, it is impt to design the policy accdg to the specific needs of the org
1. by inv instrument – prevent over inv in one type of instr
2. by financial institution – prevent over inv in one fin inst
3. by maturity scheduling – meet cash flow needs; provide guidelines for relatively
Less technical inv reporting should be generated on a regular basis to inform mgmt and
elected officials re status of the inv portfolio, changing market conditions and other
Policy should be reviewed annually and changes made as new inv legislation become
law, as staffing capabilities change or as other external or internal issues arise – should be
readopted every time there is a change.
Instruments subject to market price risk must be avoided completely if the prudent
standard applies to each security.
Public entities with portfolios of sufficient size are urged to apply the prudence concept
to the overall portfolio. This does not mean that individual sec should be speculative in
nature but rather than the inv prog be designed to anticipate occasional credit or market
risks that can be consciously offset thru diversification.
Risk is inherent in the investment world and that control and discipline are the guiding
forces to be employed in the inv prog. By arranging to have securities held by a third
party, govt can effectively minimize custodial risk in an inv transaction.
General obligation bonds:
typically issued to finance govt impvt to benefit community as a whole
secured by unlimited tax levy
readily acceptable and have lower interest rates
do not require debt service reserve fund
lower cost to issue compared to revenue bonds
subject to state limitations in amount of GO bonds
voter approval often required
debt limitation – necessitated issuance of limited tax GO (e.g., may pledge to levy
prop tax up to a specified millage rate to support debt service payment)
issued to finance facilities that have user or revenue base
secured by specific source of funs, rather than be general taxing powers
voter approval not usually necessary
considered less secure than GO bond
to enhance security jurisdictions may issue double barreled bonds w/c are secured
both by a dedicated revenue source and gen taxing powers of the jurisdiction
subject to more stringent issuance requirements than GO bonds
may be required to maintain debt service reserve fund
may require bond insurance
Financing instruments for CIP
Special assessment or special impvt district – benefit a specific area – higher interest cost
Tax increment financing (TIF) – promote economic dev – debt service is derived from
increase in tax rev as result of economic growth
Leasing – appropriate for assets too expensive to fund with current receipts but w/short
Certificates of participation (COPs) – lease purchase agreements – risk = sub to annual
appropriation of revenues and municipality may fail to do so – COPs carry lower credit
rating than GO bonds, so higher interest rates
Purpose of credit rating – provides an easily understandable measure of the degree of
risk of an issuer’s securities.
3 major rating agencies: Moody’s, Standard & Poor’s and Fitch
Major concern is the willingness and ability of the issuer to repay the debt on time and in
4 primary factors credit analyst will focus on GO bond rating:
1. debt management – ability to support existing and planned debt
2. administrative issues – org and powers of the govt’s org
3. financial performance – rev/exp trends, adequacy and dependability of revenues
4. economic base – outlook, focusing on income, population, employment, diversity,
real estate values
In analyzing revenue bonds, credit analyst uses above factors plus other factors such as
review of legal and financial agreements or trust indenture.
The timing and amount of revenue receipts are particularly impt for short-term debt
Local officials have limited control over certain factors for credit rating. Security for the
bond is one they have no control by assigning a first lien of pledged revenues to the
bondholders – also instituting sound management practices; keeping expense growth in
Bond proceeds – should have separate investment policy
require diff investment strategy than cash operating cash
yields regulated by feds for tax exempt – re arbitrage
state statutes and covenants also control how funds are invested
Investing bond proceeds – depends on the inv horizon, and degree of flexibility and
1. SLG’s – time deposits, zero interest, demand deposit
2. LGIP – check if pool accepts these deposits and if it provides record keeping
3. Mutual fund – MMMF
4. Investment agreements
5. Flex repos – pay fixed interest rate and allow investors to withdraw funds as need
6. Direct investment – bank CD’s govt sec
Arbitrage speed trap: when excess earnings by w/c inv income exceeds the bond yield
net of borrowing costs
Arbitrage compliance strategies:
1. think small - $5 million issue or less
2. blow-out – short time intervals and spend 95% within 6 months
3. arbitrage fairy – hope congress will repeal rebate provisions of 1986 TRA
4. lucky devils – by investing bond proceeds in tax exempt sec, able to earn a positive
spread and avoid rebate and reporting req
5. ostrich strategy – local decision will simply not pay rebate to fed govt
6. if you can’t lick them join them – inv in SLUGS or SLGS
7. big brother program – state design special prog for local govt
8. dumb like a fox strategy
How to develop arbitrage inv prog:
1. consult w/advisors and bond counsel
2. explore tax exempt securities
3. determine how you will perform rebate calc
4. explore alternative inv instr
5. do not commingle bond proceeds w/operating cash
6. obtain the most recent copy of arbitrage and inv reg issued by US Treas Dept
SHORT TERM BORROWING
Access to credit markets is not guaranteed and depends on:
creditworthiness of issuer
demonstrated record of perf in the credit market based on prior issues
favorable market environment w/stable interest rates
ability and experience of management in implementing financial plan
Too much short-term debt can lead to fiscal problems – short term borrowing for
operating purposes should always be repaid by the end of the fiscal year in w/c the funds
were borrowed. Tax exempt commercial paper may not be cost-effective or practical for
short-term debt for small govt.
An impt issue for govt engaged in short term borrowing is the effect that such borrowing
has on creditworthiness. Long-term debt ratings may be jeopardized by govt engaging in
too much short-term borrowing.
Can obtain short term financing thru:
1. local banks – bank loans most common
2. regional and national credit markets
3. state liquidity pools
The cost of borrowing is dependent not only on the type of financing used but on
circumstances in the financial markets. The shape of the yield curve (positive, flat or
inverted) represents the relationship between short and long term interest rate.
Historically, the yield curve for tax exempt municipal obligations has been upward
2 borrowing strategies to meet cash req: lump sum financing or as needed financing –
both are subj to TRA of 1986, state, local laws and debt policies.
In evaluating short-term debt, the rating agencies generally consider the ff:
1. security pledged
2. cash flow
3. management capabilities
Pension funds investment:
1. short term securities – cash and cash equivalents
2. fixed income securities – govt sec, inv grade corp bonds, GICs
3. equity securities – common and preferred stock
4. real estate
5. commodities, derivatives, futures and options, securities lending
Asset allocation: tool used to control and manage the risk of a pension inv portfolio and
to enhance perf of portfolio – can help simplify the inv decision making for pension
Active vs. passive investment management:
Passive management techniques:
1. create a liquidity pool
2. cover the next disbursement
3. invest to the maximum term under the cash budget
4. maintain constant maturity
Active portfolio management strategies:
1. take credit risks for yield
2. ride the yield curve – buy longer maturities in anticipation of selling them later at the
same or lower interest rate – risk is rising interest rate
3. spreads and swaps – opportunity to arbitrage
4. special situations, e.g., junk bonds
5. market timing – on the average it’s impossible to be successful market timers – for
every buyer, there’s a seller – somebody has to be wrong about direction of interest
6. hire an external manager
PERFORMANCE EVALUATION AND REPORTING
designed to measure the achievement of all cash management objectives – answer
legal compliance, credit risk, market risk and liquidity risk.
absence of performance report inhibits the public’s right to hold managers
accountable for results
complete the cash manager’s stewardship responsibilities
serves as vehicle for verifying transactions both internally and externally
serves as measuring device – compared to what?
benchmarks should be related goals, objectives and constraints in the inv policy
1. simple and speak plainly
3. portray relationship of performance to the elements in the inv pol obj
4. degree attained regarding risk and restrictions
5. hones – w/o distortion of favorable and unfavorable
Purpose of benchmark is not to find fault but to indicate whether the patters of inv
decisions is achieving the desired results.
The simplest measurement of portfolio return is interest earnings divided by average
daily cash balances – reasonable measurement for portfolio w/very short average
maturity w/passive strategy in w/c sec are held to maturity.
Total return = sum of acc interest + changes in portfolio value
Beg market value of port. + price of inv purchased during period
Principal advantage of marking to market is that it reflects both interest earned and
changes in portfolio value.
CASH MANAGEMENT TECHNOLOGY
In this hectic environment computer tech is regarded as potential solution to many of the
problems facing cash managers. Computer tech however has not been altogether a good
Computer tech has been brought to the forefront of modern finance b/c:
ability to organize and analyze info
maintain current records
quickly perform complicated calc
communicate almost instantaneously w/other computer
The needs analysis or functional requirements analysis is probably the most important
single step in the acquisition of any piece of software.
Specific functional requirements for cash management:
1. cash forecasting
2. cash position management
3. investment management
4. debt management
5. bank management
3 types of reports useful for cash forecast:
1. historical detail report – cash forecasts make the greatest cont to cash management
prog when they are based on historical experience, supplemented by informed
judgment about future events
2. detailed cash forecast – compare actual receipts and disbursements
3. investment management
4. debt management
5. bank management
The purpose of cash position management is to track cash transactions by maintaining
records of bank balances, daily receipts and disbursements, investment income, debt
payments and compensating balances.
The goal of investment management is to max the income earned on cash invested on
short term, low risk securities.
Bank index = electronic rolodex file – keeps track of individual bank accounts, signers,
authorized limits, address and contact person.
Some of the criteria in evaluating general aspects of software:
system back up
Methods of acquiring software:
1. internal development – staff
2. external development – could be off the shelf package/hire outside developer
3. hybrid – joint design and programming by one or several jurisdictions and outside
Steps in acquiring software:
1. needs definition – most important step
2. software selection
3. system evaluation
4. system implementation
Guidelines for internal software dev:
1. develop a plan
2. stick to the plan
3. plan to expand
Guidelines for external dev or acq:
1. develop your RFP
2. evaluate the responses
3. vendor presentation
4. check vendor references
INTERNAL CONTROLS & FRAUD PREVENTION
Good stewardship requires that assets be properly safeguarded, managed and accounted
1. safeguarding – protect govt’s assets against danger of loss or misuse and ensure that
all transactions are properly authorized
2. management – use assets efficiently and effectively
3. accountability – report on stewardship of public resources; not enough that an acctg
system properly manipulates data; the underlying data must be reliable
Elements of an effective internal control structure:
1. control environment – employees must view acctg sys and control procedures as an
essential and integral part of the process of providing services to the citizens
2. accounting system – properly designed and maintained
3. control policies and procedures – must be in place to ensure integrity of the data;
assets are protected against loss and misuse
Effective management involvement in internal controls requires the ff:
set the tone – if management attaches importance, so will employees
While larger govt must have a control and reporting sys to simply account for greater
resources, smaller govt have even more critical needs since they lack the margin of safety
and greater tolerance of error.
5 obj of internal controls:
1. provide reliable data for management
2. safeguard assets and records
3. establish accountability for assets
4. promote operational efficiency
5. assure transactions are recorded according to GAAP
Functions should be fixed and separated in 3 different types of activities:
1. authorization of transactions
2. recording of transactions
3. maintaining custody of assets
5 essentials of good cash acctg sys:
provides accurate and current data
allows interest allocation on daily cash balances by fund
permits cash budget to actual comparison
provides info for reconciliation
supplies cash balance info for investment
Accounting system effective if:
1. existence or occurrence – assets and liabilities recorded actually exist and events
2. completeness – no assets and liability were omitted
3. rights and obligations – assets and liability recorded are in fact of the govt
4. allocation – transactions are recorded in the right period
5. presentation and disclosure – follows GAAP
The systematic process used to establish priorities based upon risk is known as
vulnerability assessment. Weak internal controls are the primary factors contributing to
Costs of fraud:
1. loss of public confidence in govt
2. loss of reputation of the innocent
3. punishment of the perpetrator
Kiting – a classic scheme for hiding the absence of “borrowed” funds
Lapping – another classic “borrowing” scheme built on the premise of “robbing Peter to
Pilfering – petty theft of supplies and similar items of small monetary values
Detecting fraud through:
1. analytical review
2. unusual transactions
3. unusual documentation
slow processing of revenue receipts
slow deposit of receipts
lack of incentive to pursue collections
weak enforcement of revenue laws
determining what is owed
poorly trained staff
lack of internal controls
poor records management
Factors affecting size of collections staff:
volume of collections
size of government
level of automation
internal control concerns
extent to w/c third party agents are used
level of delinquencies
Of paramount importance is the personal safety of those working in the collections
office. Of secondary importance is the security of the money collected. Staff of the
revenue collections office may also be personally liable for the money in their custody.
3 types of surety bonding: blanket, individual and name or position-schedule bonds
Primary Market for T-Bills:
a. 3, 6, & 12 month maturities
b. Book entry-reduced risk that securities will be lost, stolen, or destroyed
c. Regular auction for T-bills, and also cash management bills
i. CM bills are re-openings or sales of bills w/same maturity as outstanding
issues. These follow 5 major individual corporate income tax payment
dates - $10 Million minimum
2. Offering – (13 and 26 week only)
a. Announced – Tuesday
b. Auctioned – following Monday
c. Issued – following Thursday
a. Announced – 4th Friday of month
b. Auctioned – following Thursday
c. Issued – Thursday, a week later
For any days falling on a holiday, next business day is used.
Tenders – issued by the purchaser to submit bids on competitive basis. Bids are to 2
Non-competitive bids –
Average price of competitive bids
Maximum of $1 million
Anything over $1 must go competitive bid route
Bids are submitted to Fed Reserve or any member branch
All non-competitive bids are accepted first, then to lowest discount rates to the
Stopout price is the highest yield competitive bids are accepted at
Average price of tenders (which tends to be closer to the lowest bids) is used as
basis for acceptance of non-competitive bids
% of non-comp. Bids rises during high interest rate periods
When-Issued (very speculative)
Between the auction and issue active trading takes place
Forward commitments between dealers to buy & sell securities when
Govt’s are not advised to get into this market
All trading takes place on discount basis
1. a 360-day bill discounted at $% = $100 par - $4 discount = $96 (price)
the effective yield is 4/96 (not 4/100) or 4.17% per year!!!
2. If this were 283 days instead:
Annualize this to find the true full discount
(283/360) x .04 = 3.144 (full discount)
the price would then be $100 - $3.144 or $96.856
Yield: calculated on an annualized basis:
Take the full discount (3.144) x (365/283)(to annualize term)??= 4.055 which is
annual basis of discount
To figure yield – 4.055 x (1/96.856) x 1000 = 4.187/yr this compares to orig disc
Treasury notes & bonds
a. These are coupon securities (they pay interest every 6 months)
b. Notes (at the time of issue) are > 1 yr but < 10 yrs
These are not money market securities because their term exceeds 1 yr. (My
understanding is that money market funds are defined as > 2 yrs, whereas money
market securities are < 1 yr.)
Coupon securities – ($5,000 and higher), (multiples of $1,000) for maturities < 4 yrs at
issuance. Any coupon securities > 4 yrs at issuance – minimum $1,000, with multiples of
Bearer, or registered, owners
Bearers redeem coupons every 6 months, registered interest goes direct to reg
owners. Most have coupon dates 15th or end of month.
Secondary market for T-notes & Bonds:
No centralized exchange (phone market?)
Prices are quoted in 32/nds of a point – 104.8 on a $10,000 note or bond means
(10) x (104 x 10 x 8 x .3125) = $10,425
104.8+ means 104 + 17/64 or 104 +8/32 + 1/64 = 104 + 16/32 + 1/64 = 104 17/64
U.S. Gov’t Agency Securities
True agency securities, backed by full faith & credit of US Govt.
There seems to be some discrepancy as to whether TVA notes are true agency. They are
listed differently in Girard Miller’s book and some of the other reading material……
The key difference between true agencies & instrumentalities is Liquidity &
Marketability GNMA’s are the only commonly used Gov’t Agency type that is fully
backed by US Govt
Instrumentalities are exempt from SEC Registration, although there is an implicit
guarantee by US Govt
GNMA’s provide secondary market for Real Estate Mortgages (used to spur private
hosing in the economy)
SBA notes are for small business concerns & to assist victims of natural disasters
TVA – rarely issued debt – if it does, long-term in nature – and certainly not appropriate
for short-term Govt investing – used for pension funds only
Instrumentality notes are not guaranteed (princ. & interest) by U.S. govt, but by
sponsoring corporation itself.
Money Market Mutual Funds
1. Seek to maintain a $1 per share price usually no-load, open-ended investment
companies regulated by the SEC
2. 1 year or less – average maturity is 90 days
3. Not eligible for FDIC insurance (because portfolio usually contains guaranteed or
insured instruments anyway)
4. Main advantage is professional money mgt feature – very liquid (same day)
5. Good when yield curve is normal or upward sloping
Federal Reserve Open Market Operation:
When the Fed buys:
1. Decreases short-term interest rates
2. Increases the money supply
3. Increases the price of Govt securities
4. Increases demand for Govt securities in secondary market
When the Fed sells:
1. Drains reserve from the banking system
2. Decreases price of Govt securities
3. Increases short-term interest rates
4. Decreases the money supply
Triple Barreled – backed by:
1. Issuer’s guarantee to pay
2. Underlying goods being financed
3. Guarantee of the accepting bank
BA’s are 30 days to 270 days, mostly in the 90-day range
Shorter maturities in the secondary market
Increments typically $100K, $500K, and $1 Million
1. Short-term promissory notes – unsecured
2. Maximum 270 days, majority are 30-50 days
3. Sold at a discount
4. Minimum denomination of $100K
Purchases should get credit ratings on firms because of credit risk
Nothing new here, only that they are not required to register w/SEC-because of Gov’t
Money Market Mutual Funds:
1. Regulated by SEC
2. Must comply w/Rue 2a7, which governs credit quality, diversification practices, and
maturities of portfolios
3. SEC requires 95% of MMMF portfolio consist of Gov’t securities or money market
instruments rated A-1/P-1 by national recognized rating agencies
4. Maturities are limited to 1 year
5. Avg portfolio maturity is 90 days or less
6. MMMF seek to maintain Net Asset Value of $1
GFOA RECOMMENDED PRACTICES
COLLATERALIZATION OF PUBLIC DEPOSITS
A. Public entities should implement programs of prudent risk control – formal
depository risk policy, credit analysis, and use of fully secured investments. If
locality does not use statewide collateralization program, should have its own.
B. Make sure collateral interests are enforceable against receiver of a failed
institution. Agreements should be:
1. In writing
2. Executed by proper people
3. Approved by financial institution board or loan committee
4. An official record of the depository institution continuously
GOVERNMENTAL RELATIONSHIPS WITH SECURITIES DEALERS
Recommends for Govt’s selecting depositories & SEC dealers:
A. Select thru competitive procedures – use RFPs for banking services
B. Make sure SEC, dealers comply with Fed Reserve Bank of NY’s capital
adequacy guidelines (must maintain minimum capital adequacy ratio of liquid
capital to measured risk that meets or exceeds 125%)
C. Get acknowledgements from deposits, and dealers that they have received copies
of investment policy, portfolio risk constraints, and investment trading
D. Depositories & dealers must be aware of market risk, liquidity and credit risk
before they invest. Securities dealers have a responsibility to disclose
REPURCHASE AGREEMENTS, REVERSE REPOs, LEVERAGING &
PRUDENT INVESTMENT PRACTICES
Reverse Repo’s have two basic uses:
a. a way to avoid liquidating portfolio to meet short-term cash requirements.
b. to enhance portfolio returns thru leveraging (higher yielding instruments)
1. Exercise caution in selecting parties for REPO transactions.
2. Properly collateralize. Use “haircuts” or overcollateralization & mark to
3. Have master repo agreement – deals with delivery, substitution, margin
maintenance, margin amounts, seller representations, and governing law.
4. Report proceeds should generally not be invested in securities whose maturity
lengths do not match the term of Rev. Repo. Borrowing short to lend long is
bad in adverse markets.
5. Reverse Repo’s should be considered only by entities with expertise &
6. Govt’s should not buy on margin (by borrowing funds from a counterparty),
selling securities short (by borrowing security from a 3rd party in anticipation
of higher interest rates, purchasing long-term bonds w/short-term funds, and
trading futures contracts without an exact offsetting cash market position.
VARIOUS TYPES OF MUTUAL FUNDS
GFOA recommends govts carefully review credentials, procedures and controls of firms
offering investment advisory services.
Recommends precautionary measures including:
1. Delivery vs Payment
2. 3rd party custody
3. no self-dealing
4. independent audits
5. timely reconciliations
6. other appropriate internal controls
USE OF DERIVATIVES
(Includes CMO’s, IO’s, PO’s, Forwards, Futures, Currency Rate & Interest Rate Swaps,
Options, Floaters/Inverse floaters, caps/floors/collars – Governments may use them – but
must use extreme caution.
1. Certain products may not be appropriate for all govt investors.
2. Should understand local laws may not specifically address use of derivatives. Should
examine constitutional authority to execute derivative contracts.
3. Be aware of all risks.
4. Have internal controls in place for each type of derivative products – written policies
and procedures or objectives, how to monitor them, have expertise to manage them.
5. Determine whether broker/dealers is an agent in the transaction or takes a proprietary
6. Be aware there may be no pricing mechanism for some derivative products.
7. Make sure caution is exercised in selecting brokers/dealers.
8. Ensure same level of safeguards if using 3rd party, make sure they act on behalf of
MARKING TO MARKET
1. Public should remain informed of market value of govt portfolios
2. Values should be obtained from independent 3rd party at least quarterly.
3. LGIP’s unless 2a7 like pools, should also mark to market at least monthly, and report
to pool participants at least quarterly.
1. GFOA recommends govts augment information brokers/dealers and advisers supply
with independent research.
2. Invest in only those CMO’s that seek market risk ratings from rating agencies to
provide comprehensive disclosure to investors.
MASTER TRUST & CUSTODIAL BANK SECURITY LENDING PROGRAMS
1. Security lending transactions are similar to Reverse Repo’s
2. GFOA recommended only extreme use of security lending transactions. Finance
officers should evaluate:
c. reinvestment guidelines
e. credit risks
f. monitor compliance
Degree of risk assumed by lending agent is reflected in the split of proceeds.
DIVERSIFICATION OF INVESTMENTS
GFOA recommends diversification by:
1. limit concentration of specific issues or business sectors.
2. limit high risk securities.
3. invest with varying maturities.
4. keep portion of portfolio liquid (LGIP’s, etc.)
MATURITIES OF INVESTMENTS
GFOA recommends matching investment maturities with cash flow requirements
1. should not invest > 5 years unless matched for specific cash requirement – intent
should be in writing if beyond 5 years.
2. adopt weighted average maturities
3. a set portion should be total liquid to meet ongoing obligations
PROCUREMENT OF BANKING SERVICES
1. Periodically initiate competitive (RFP) bidding process for major banking services
2. Contracts should disclose fee structure (or compensating balance arrangement)
3. Re-evaluate benefits and costs. Compensating balances can be costly because of low
earnings allowance rates, reserve requirements, and insurance fees on deposits.
4. Keep in mind costs and benefits of
a. controlled disbursement accounts
b. zero balance accounts
c. positive pay services
d. reconciliation services
e. lock boxes
f. electronic means of all kinds
g. sweep accounts
h. safekeeping and custody, credit cards