Avoiding Unsound Investments

Every five or ten years, a group of local governments loses a significant amount of money in unwise investments and serves as a reminder to all local governments that public moneys must be invested prudently and cautiously. Such losses took place over the last few years in Orange County and other counties in California, and in the states of Ohio, Texas, West Virginia and Wisconsin. Some school districts in Pennsylvania also suffered significant investment losses in 1997.

Oftentimes local governments get into trouble by investing in securities with maturities which exceed their liquidity needs. In some cases, such as in Orange County, the local governments may also have leveraged their positions through the use of reverse repurchase agreements and securities lending. As a result of these practices, local governments can lose a significant portion of their original investment.

Please be aware that there is legislation which will be introduced in 1999 in the Pennsylvania legislature which would substantially revise the investment provisions affecting local governments.

Here are a few suggestions on ways to avoid investment problems:

1. Know which investments are legal under your code. Make sure you obtain from your solicitor a copy of the statute which describes your legal investments. Here are the citations to the appropriate Pennsylvania statutes for various types of entities: Townships of the First Class - 53 P.S. §56705.1; Townships of the Second Class - 53 P.S. §68204; Boroughs - 53 P.S. §46316; School Districts - 24 P.S. §4-440.1; Municipal Authorities - 53 P.S. §309.1; Cities of the Second Class - 53 P.S. §5410; Cities of the Third Class - 53 P.S. §36804.1; Counties of the Second Class - 16 P.S. §4964; and Counties of the Third through Eighth Classes - 16 P.S. §1706. Review your statute with your solicitor so that you understand which investments are legal.

2. Develop a sound business practice. Almost all of these investment statutes state that the local government shall invest its moneys "consistent with sound business practice." Some of the statutes go on to set standards for prudent investing; they provide that the local government should "exercise that degree of judgment, skill and care under the circumstances then prevailing which persons of prudence, discretion and intelligence, who are familiar with such matters, exercise in the management of their own affairs not in regard to speculation, but in regard to the permanent disposition of the funds, considering the probable income to be derived therefrom as well as the probable safety of their capital."

These standards can be restated in a more straightforward manner: (1) avoid speculation; (2) do not do anything you would not do with your own money; (3) do not invest in any investment you do not understand; and (4) understand the return that can be earned and the risks involved and err strongly on the side of preserving the safety of the principal.

Most of the investment statutes require that the governing body develop an investment program. Such a program can set forth general guidelines which the local government's finance officer should follow in making investments.

3. Certificates of Deposit: FDIC Insurance. If you invest in certificates of deposit, or if you deposit moneys in other accounts in banks or savings and loans, make sure you understand how your deposit is protected. There are two ways your deposit can be protected: Federal Deposit Insurance Corporation ("FDIC") insurance or a pledge of collateral.

A local government investing in an insured institution located in the same state is insured by FDIC up to $100,000 for all demand deposits combined (checking accounts bearing no interest) plus up to $100,000 for all time and savings deposits combined (such as NOW accounts, money market accounts, savings accounts and certificates of deposit). For example, a Pennsylvania local government with $30,000 in a demand checking account, $60,000 in a savings account and $60,000 in a certificate of deposit in a Pennsylvania institution would be insured for the full $30,000 in the checking account and for $100,000 of the $120,000 in the savings account and certificate of deposit.

A Pennsylvania local government is insured by FDIC up to $100,000 for all accounts combined in an out-of-state insured institution. For example, a Pennsylvania local government with $30,000 in a demand checking account, $60,000 in a savings account and $60,000 in a certificate of deposit in an insured institution located in Maryland would be insured up to $100,000 and would be uninsured for $50,000.

With respect to 457 Plans, the general rule is that each participant in the plan is insured by FDIC up to $100,000 provided the institution meets the minimum capital requirements of FDIC. Be sure to check that the institution which holds your 457 Plan funds meets these minimal capital requirements.

4. Certificates of Deposit: Collateralization. If a local government has money in an institution in excess of the FDIC insurance limit, the local government unit should make sure that the institution pledges the institution's own securities as collateral for the deposit. Usually the securities pledged by the institution are U.S. Government securities.

The collateral pledge can be handled in one of two ways. The government unit and the institution can enter into a two-party agreement under which the institution pledges securities to secure only that local government's deposits, or the institution can pledge a pool of securities to secure on a joint basis the deposits of many local government units pursuant to Act 72 of 1971.

Whichever way your deposits are collateralized, make sure that:

* you have a written agreement with the institution regarding the collateral pledge;
* the pledge is approved by the institution's board of directors or loan committee, and such approval is reflected in the institution's minutes and is kept continuously as an official record of the institution;
* the market value (not just the face value) of the pledged securities is tested frequently and is at least equal to the amount of the deposits plus accrued interest;
* the pledged securities are U.S. Government Securities; and
* you request from the bank monthly reports on the amount of your deposit, the identity of the collateral and the market value of the collateral.

5. U.S. Government Securities. Local governments may invest in securities of the U.S. Government or its agencies or instrumentalities which are backed by the full faith and credit of the United States (such as U.S. Treasury notes, bills or bonds and securities of the Government National Mortgage Association). These are the most secure investments in the world. Credit risk is not a concern, but you still need to be concerned about market risk. Make sure that you match the length of the investment to your anticipated need for the money. If you have to sell a U.S. Government or any other investment security before its maturity, you take the risk that a rise in interest rates will lower the market value of your security, and you could be facing a loss.

Local governments may also invest in short-term obligations of the U.S. Government or its agencies or instrumentalities, whether or not such securities are backed by the full faith and credit of the U.S. Government. These generally are also very secure investments. "Short term" is usually understood to mean one year or less.

Be sure you fully understand the nature of the particular Federal agency security before investing. You may be approached to buy collateralized mortgage obligations ("CMOs") or individual principal or interest payments of a larger security ("STRIPS"). These are the sorts of investments which are subject to significant market risk. If you are being offered very high interest rates, it is only because you are subjecting yourself to increased risk with respect to your initial deposit. There is no free lunch.

You can also buy U.S. Government securities under a repurchase agreement with a bank or a broker. You purchase the securities subject to an agreement to sell them back to the other party on a specific date at a specific price. If you do enter into repurchase agreements, be sure (1) the other party is a solvent institution, (2) you sign a written agreement, (3) the securities are actually delivered to your custodian and are held in an account in your name, and (4) the securities have a market value at least equal to the amount of your purchase price plus accrued interest.

6. Other Investments. If you invest in local government investment pools or in investment companies which in turn invest in U.S. Government securities and certificates of deposit, you should obtain and read the prospectus carefully to make sure you understand how your money is being invested.

Certain counties and cities are authorized to invest in commercial paper, which consists of short-term, unsecured notes of private corporations. The credit worthiness of the corporate issuers varies considerably, and you should only invest in commercial paper if you are very familiar with that market.

These materials are intended to furnish general information and should not be relied upon as advice in specific situations.

David Unkovic
Saul Ewing LLP
Centre Square West
1500 Market Street, 38th Floor
Philadelphia, PA 19102
(215) 972-7750 fax: (215) 972-1928
e-mail: [email protected]
web: www.saul.com