23.4 Authorized Public Investment Instruments: Comparative Analysis

Authorized Public Investment Instruments: Comparative Analysis

State statutory codes and local investment policies authorize specific fixed-income instruments suitable for public funds:

+---------------------------------------------------------------------------------------------------+
|                         AUTHORIZED PUBLIC INVESTMENT INSTRUMENT MATRIX                            |
+--------------------+-------------------------+----------------------+-----------------------------+
|  SECURITY TYPE     |  CREDIT BACKING         |  LIQUIDITY PROFILE   |  RISK / POLICY CONTROLS     |
+--------------------+-------------------------+----------------------+-----------------------------+
|  U.S. Treasuries   |  Full Faith & Credit of |  Exceptional /       |  Zero credit risk; maximum  |
|  (Bills, Notes)    |  U.S. Federal Government|  Immediate Secondary |  maturity limits (e.g. 5 yrs)|
+--------------------+-------------------------+----------------------+-----------------------------+
|  Federal Agencies  |  Explicit (Ginnie Mae)  |  High Secondary      |  Cap per agency (e.g. 35%); |
|  (GSE Obligations) |  or Implied (Fannie,    |  Market Liquidity    |  GSEs carry implicit credit |
|                    |  Freddie, FHLB, FFCB)   |                      |  risk vs. U.S. Treasuries   |
+--------------------+-------------------------+----------------------+-----------------------------+
|  Certificates of   |  FDIC Insured up to     |  Low Secondary       |  Collateralization required |
|  Deposit (CDs)     |  $250k; Pledged Collateral| Liquidity (Penalty |  on balances >$250k;        |
|                    |  for Uninsured Balances |  for Early Break)    |  use CDARS / IntraFi network|
+--------------------+-------------------------+----------------------+-----------------------------+
|  Repurchase        |  Fully Collateralized   |  High Short-Term     |  SIFMA Master Repo Agreement|
|  Agreements        |  by Pledged U.S.        |  (Overnight to       |  Tri-party agent; 102%      |
|  (Repos)           |  Treasuries / Agencies  |  30-day terms)       |  margin haircut; daily mark |
+--------------------+-------------------------+----------------------+-----------------------------+
|  Prime Commercial  |  Unsecured Promissory   |  Moderate            |  Top short-term rating only |
|  Paper (CP)        |  Note of Corporate      |  (Held to Maturity)  |  (A-1/P-1/F-1); max 270 days|
|                    |  Commercial Issuers     |                      |  Max 15%–25% total portfolio|
+--------------------+-------------------------+----------------------+-----------------------------+
|  Municipal Debt    |  General Obligation /   |  Moderate Secondary  |  Minimum rating (AA/Aa);    |
|  (Bonds/Notes)     |  Pledged Net Revenues   |  Market Liquidity    |  issuer caps; legal analysis|
+--------------------+-------------------------+----------------------+-----------------------------+
|  Local Govt Invest-|  Diversified High-Grade |  Highest (Same-Day / |  SEC Rule 2a-7 compliant;   |
|  ment Pools (LGIP) |  Short-Term Assets      |  Next-Day Liquidity) |  Stable $1.00 NAV preferred |
+--------------------+-------------------------+----------------------+-----------------------------+

1. U.S. Treasury Securities

Direct obligations issued by the United States Department of the Treasury, backed by the full faith and credit of the federal government. They represent the benchmark risk-free credit asset:

• Treasury Bills (T-Bills): Short-term obligations issued at a discount with maturities of 4, 8, 13, 17, 26, and 52 weeks. Return is realized as the difference between the purchase price and face value at maturity.
• Treasury Notes (T-Notes): Intermediate obligations with fixed semi-annual coupon payments and stated maturities ranging from 2 to 10 years.
• Treasury Bonds (T-Bonds): Long-term obligations with maturities of 20 to 30 years (rarely authorized for public operating funds; restricted to long-term permanent funds or debt reserves).

2. Federal Agency Obligations and Government-Sponsored Enterprises (GSEs)

Debt securities issued by federal agencies or chartered corporations:

• Full Faith and Credit Federal Agencies: Government National Mortgage Association (Ginnie Mae / GNMA), Export-Import Bank, and Small Business Administration (SBA). These obligations carry the explicit, legally binding full faith and credit backing of the U.S. government.
• Government-Sponsored Enterprises (GSEs): Federal National Mortgage Association (Fannie Mae / FNMA), Federal Home Loan Mortgage Corporation (Freddie Mac / FHLMC), Federal Home Loan Banks (FHLB), and Federal Farm Credit Banks (FFCB). GSEs are privately owned, congressionally chartered entities. Their obligations carry an implied federal guarantee, backed by lines of credit with the U.S. Treasury, but are not legal obligations of the U.S. government. They offer slightly higher yields to compensate for this minor credit differential.

3. Certificates of Deposit (CDs)

Time deposits placed with insured commercial banks or credit unions:

• Balances up to $250,000 are fully insured by the FDIC or National Credit Union Share Insurance Fund (NCUSIF).
• Balances exceeding $250,000 must be 100% collateralized with pledged securities or placed through reciprocal deposit networks such as CDARS (Certificate of Deposit Account Registry Service / IntraFi Network), which programmatically divides multi-million dollar deposits into increments under $250,000 distributed across a nationwide network of participating banks to secure full FDIC insurance on every dollar.

4. Repurchase Agreements (Repos)

A Repurchase Agreement (Repo) is a contractual financial transaction where a public entity (the buyer) purchases authorized securities (typically U.S. Treasuries or Agencies) from a primary broker-dealer or bank (the seller), with a simultaneous legal agreement that the seller will repurchase the identical securities on a specified future date (often overnight or within 30 days) at an agreed-upon higher price reflecting a fixed rate of interest:

• Master Repurchase Agreement (MRA): All repo transactions must be executed under a legally binding, standardized SIFMA Master Repurchase Agreement that clearly establishes the transaction as a purchase-and-sale rather than a loan, governing default remedies and margin rights.
• Collateralization and Margin Haircuts: The market value of the underlying collateral securities pledged to the government must exceed the cash purchase price—typically mandated at 102% for Treasuries and 104% for mortgage-backed agency obligations. If the market value of the collateral drops due to interest rate fluctuations, the dealer must post additional collateral immediately (margin call).
• Tri-Party Repurchase Agreements: The preferred institutional repo structure. An independent custodian clearing bank (e.g., BNY Mellon) acts as a neutral third-party intermediary. The clearing bank verifies that eligible collateral securities are transferred from the dealer's book into the government's segregated account before cash is wired to the dealer, continuously monitoring the 102% margin valuation daily.

5. Prime Commercial Paper (CP)

Short-term, unsecured promissory notes issued by major corporations to finance immediate working capital and accounts receivable:

• Because commercial paper is completely unsecured (backed solely by the creditworthiness and cash flow of the corporate issuer), public investment policies impose strict statutory safeguards:
  1. Credit Rating Floor: Must hold the highest short-term credit rating from at least two NRSROs (e.g., A-1 by S&P, P-1 by Moody's, and F-1 by Fitch). "Split-rated" paper (e.g., A-1 by S&P but P-2 by Moody's) is strictly unauthorized.
  2. Maturity Limits: Federal statutory exemption under Section 3(a)(3) of the Securities Act of 1933 caps commercial paper maturities at 270 days. Most public entities impose an internal policy cap of 90 to 180 days.
  3. Portfolio Concentration Limits: To guard against corporate default, public policies typically cap total commercial paper holdings at 15% to 25% of the entity's total portfolio, with no more than 3% to 5% invested in any single corporate issuer.

6. Local Government Investment Pools (LGIPs)

Cooperative investment arrangements organized under state joint-powers legislation or administered directly by the State Treasurer:

• Enable local governments (cities, counties, school districts, special fire districts) to pool their surplus cash reserves to achieve economies of scale, professional institutional management, extensive diversification, and enhanced liquidity.
• SEC Rule 2a-7 Structure: Most government pools operate pursuant to the standards of the SEC's Rule 2a-7 of the Investment Company Act of 1940 (or GASB Statement No. 79), utilizing the amortized cost accounting method to maintain a constant Net Asset Value (NAV) of $1.00 per share. Local entities can deposit and withdraw cash daily without experiencing capital gains or losses.
• Variable NAV Pools: Pools that manage longer-duration assets (1 to 3 years) fluctuate in NAV (fair value). While offering higher potential yields, they expose the public entity to fair market valuation adjustments and are inappropriate for immediate operating liquidity.

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Safekeeping, Collateralization & Delivery Versus Payment (DVP)

Two catastrophic operational vulnerabilities in public treasury management are counterparty delivery failure and uncollateralized bank insolvency. Public finance policies resolve these risks through statutory collateralization and mandatory third-party custodial safekeeping.

Delivery Versus Payment (DVP): The Ironclad Settlement Rule

Authoritative Mandate: Public funds must never be released to an investment broker-dealer until the purchased securities have been verified and securely delivered to the government's independent third-party custodian bank. This simultaneous transaction protocol is known as Delivery Versus Payment (DVP).

In an unauthorized "free delivery" arrangement, a government wires cash to a broker based on a trade confirmation, expecting the broker to transfer the securities later in the afternoon. If the brokerage firm collapses or experiences a liquidity freeze before delivering the securities, the government becomes an unsecured general creditor in bankruptcy court, losing 100% of its cash. Under DVP:

1. The government executes a trade with an approved broker-dealer.
2. The government issues matching trade settlement instructions to its independent third-party trust custodian bank.
3. Through the Federal Reserve Fedwire Securities Service or the Depository Trust Company (DTC), the broker presents the securities electronically to the custodian bank.
4. The custodian bank confirms that the securities match the exact CUSIP number, maturity, par value, and coupon rate instructed by the government.
5. Simultaneously, in an indivisible transaction, the custodian bank releases the cash settlement to the broker while crediting the securities into the government's segregated custody account.

Public Deposit Collateralization Covenants

When a public entity deposits money in a commercial bank (demand deposit, ZBA master, or CD), balances exceeding the $250,000 FDIC insurance limit become an unsecured loan to the bank. If the bank fails, the municipality faces immediate loss. State statutes mandate that financial institutions holding public deposits must pledge eligible collateral to secure all uninsured balances:

• Required Collateral Margins: State laws typically mandate collateral pledged at 102%, 105%, or 110% of the uninsured collected deposit balance, marked to market daily or weekly.
• Eligible Pledged Collateral: Restricted to safe, liquid assets: U.S. Treasuries, federal agency securities, and high-grade in-state municipal obligations. Bank letters of credit issued by the Federal Home Loan Bank (FHLB) are also widely recognized as statutory collateral.
• Custodial Architecture: Collateral securities cannot remain in the possession or internal vaults of the depository bank itself. They must be deposited with an independent third-party financial institution (such as a Federal Reserve Bank or an independent trust bank) held under a Tri-Party Public Deposit Pledge Agreement naming the public entity as the sole secured party.
• Single Bank Pledging vs. Statewide Pooled Collateral: In a single-bank model, the institution segregates specific securities dedicated solely to that specific municipality. In a statewide pooled model, participating public depositories pool collateral under the supervision of the State Treasurer, creating a mutualized guarantee fund ensuring that if any single depository fails, the collective collateral pool satisfies all public deposit claims.

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