It’s Not Personal, It’s Just Business.
By Brian Reilly, CFA
Senior Municipal Advisor | Managing Director
In our prior Newsletter, we showcased the failure of Silicon Valley Bank (SVB) and used it as a cautionary tale of why public funds depositors should ensure the funds they hold with depository institutions are not subject to the risks associated with such crises. As we stated, the rapidity at which a bank’s financial condition can deteriorate won’t likely offer ample time to react, as depositors can withdraw funds at the speed of a mouse click or tap on a smartphone. In the matter of a little more than a business week, SVB went from a headline to receivership administered through the Federal Deposit Insurance Corporation (FDIC), ultimately resulting in the second largest bank failure in U.S. history.
While the FDIC and its other federal partners seem to find ways to bend over backwards to shield depositors, it really isn’t practical to rely on these extraordinary measures to protect your funds. It should be assumed that the standard insurance coverages of the FDIC and its counterpart in the credit union space, the National Credit Union Association (NCUA), will apply. That’s essentially $250,000 per depositor, although there are some aspects of FDIC and NCUA coverage that may afford a single depositor up to $500,000 in total coverage. Similarly, there are some states that provide deposit guaranty programs, but those funds are subject to appropriation and usually limited to a specific dollar amount, which may or may not be sufficient to make all public funds depositors whole.
The balances you hold with any one depository institution will likely exceed insured amounts at some point in any given fiscal year. At these junctures, you are essentially an unsecured creditor of that institution, which places you in a precarious position. It’s important to remember that, in these situations, you’ve become a lender, so you should think like one. What do lenders do when they are concerned about a borrower paying back a loan? They secure their investment in the borrower by requiring a pledge of collateral that could be legally taken and liquidated in the event of non-payment or default. Depository collateral substitutes for the credit of the bank and can make public funds depositors whole in the event of a bank failure. While some states require collateralization of uninsured deposits, many do not. Regardless, all governmental entities should consider it a best practice.
Of course, when it comes to collateralization, the devil is truly in the details. A term of art often referred to in the industry is “perfecting” collateral. This entails:
- Establishing a legal right and enforceable security interest in the assets being pledged
- Identifying what assets can be pledged as collateral and whether substitutions are allowed
- Determining where the collateral will be custodied
- Calculating the minimum amount of collateral and how those assets are periodically valued
- Defining the means by which the depositor can take control of the collateral
There are four key questions depositors need to consider when collateralizing public funds deposits”
- What’s your claim to the assets pledged as collateral? You should enter into a legal and binding pledge agreement with the pledging institution. This can often be a boilerplate document but can also be uniquely drafted by counsel of either the depositor or financial institution. The pledge agreement establishes a legal and enforceable claim to the assets pledged, including against the receiver of a failed financial institution. If your bank sent you a letter stating they are pledging “XYZ security” as collateral for your uninsured account balance, it may not be worth the paper it was printed on. The bank still holds the stated security, and you can’t be certain whether it pledged that same asset as collateral to another party or perhaps even sold it outright after the date of the letter. Further, it’s unlikely the letter would be sufficient to substantiate your claim and stand up to the scrutiny of a receiver.
- What assets are eligible to be pledged as collateral? First things first: Investment statutes dictate the specific investments governmental entities can own. If what’s being pledged to you not on the list of approved investments, it’s not eligible as collateral, just because you can’t take possession of an asset you can’t legally own. You also don’t want to be forced to immediately liquidate the collateral as soon as you take possession due to legal constraints. Some states allow surety bonds or letters of credit as eligible collateral in lieu of securities, both of which are fine. Federal Home Loan Bank letters of credit have been popular forms of collateral in recent years. Be sure you receive documentation from the pledging institution that “perfects” your interest. A confirmation from the issuing entity should state the beneficiary (your jurisdiction), the amount, the effective and expiration date, and the pledging institution. You should only accept irrevocable letters of credit.
You should also consider whether to further limit eligible collateral beyond what is allowed under statute. Municipal bonds tend to be a common pledged security as they tend to be of high credit quality, but there may not be an active secondary market for a nominally sized position of a small issuer. You may need to take a concession on the price in order to convert it to cash. The same can be said for some mortgage-backed securities. You may want to limit allowable collateral to certain issuers, rating levels, and even specific types of obligations of a particular issuer. Consult with your advisor if you want to better understand the pros and cons of limiting the universe of securities that are eligible to be pledged as collateral. The depositor and the pledging institution will also need to determine under what circumstances collateral can be substituted.
- Where is the collateral held and how do you get your hands on it? When a lender forecloses on a property to enforce its mortgage security interest, it’s a very involved process. If you are the borrower, you’re in possession of the property and maybe even still occupy it. The lender has to essentially take title from the borrower by exercising its legal remedies. You don’t have months to access what you’re entitled to (which is essentially your cash), so want to be sure you understand the custody of the pledged assets. Ideally, there should be what’s known as a “tri-party” agreement between the depositor, the pledging institution, and the custodian of the collateral. A control agreement between these parties will define under what circumstances and by what means the depositor can take control of the pledged assets. The custodian should be an entity legally distinct from and independent of the pledging institution. This ensures the collateral is held only in the interest of the depositor and not commingled with the pledging institution’s other assets.
Under a control agreement, the depositor should have the right to give notice to the custodian of the bank’s failure, which then gives rise to the immediate transfer of the collateral. Upon transfer, the depositor can sell the assets, thus turning the collateral into the cash it originally had on deposit.
- How is the collateral valued and how frequently reported? There’s an important concept here called “margin.” Margin is the difference between the amount of the uninsured deposit balance and the value of the pledged collateral. You should accept no less than 100% margin, which means those two numbers are equal. However, keep in mind that the value of financial assets changes daily. What was $1 million of pledged collateral yesterday, could be $985,000 tomorrow. Some states require as much as 10% margin, meaning the collateral must be valued at no less than 110% of the amount of the uninsured deposit. Other states have no requirements, which means you’ll need to negotiate margin with your depository institution. A good rule of thumb is 102% – 105% in the absence of a statutory requirement, but that should be viewed in the context of what you allow as eligible collateral and how often you receive a collateral register that states the assets and their reported market value. You should have the collateral marked-to-market no less than monthly. If the value falls below the stated margin, the pledging institution must put up additional collateral. If the value is higher than the stated margin, collateral can be removed accordingly. The value should be provided by an independent institution or pricing service. Also understand that you may not be able to sell the pledged assets at their reported market value, since those values are only indications based on modeling rather than actual trading values. There may be times each year when you wish to mandate a more frequent level of reporting, such as tax settlement time.
It’s imperative that finance staff have proper insight into the treasury management practices of their organization. Safeguarding public deposits should carry the highest consideration, but that’s not without some level of administrative procedure and diligence on your part. The funds for which you maintain stewardship have accumulated over the entire life of your jurisdiction, and your goal is to ensure they are there for the next generation and beyond.
Ehlers investment and treasury professionals have extensive experience analyzing depository relationships and perfecting collateral, as well as establishing written policies and procedures that will provide the foundation of stability for your organization now and into the future. We would be happy to visit with your team about this important aspect of your finance function.
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