Investing in Certificates of Deposit Patrick Shinkle University of North Texas Center for Public Management http://pacs.unt.edu/cpm/ Why Certificates of Deposit? Advantages Relatively easy to understand Set dollar amount Specified maturity Fixed interest rate Potential yield advantage to alternatives Bank Pool Securities Adds diversification 1
Why Certificates of Deposit? Disadvantages Identifying providers Authorized bank individual to commit Knowledgeable of public fund requirements Potential cumbersome and time consuming first time documentation requirements Transaction execution Time sensitive Cash flow sensitive Why Certificates of Deposit? Disadvantages Monitoring collateral values Valuation, source, method and substitution Account for accrued interest FDIC amounts and considerations Release and proper credit at maturity Early withdrawal penalty Traditional CDARS 2
Steps Compliance with the local investment policy Understanding legal issues Research the existing bank depository agreement for restrictions Understanding FDIC coverage Understanding Collateral Understanding FIRREA Understanding the CD investment Understand your cash flows Defining the methods, terms and conditions (MTCs) for structuring bids Establishing a checklist Compliance with Investment Policy Are CDs and/or CDARS listed as approved investments in the local Investment Policy? Are there restrictions/limitations for CDs in the Investment Policy? No more than % may be invested in CDs Are there collateral restrictions/limitations regarding CDs in the Investment Policy? Are CD bid solicitation methods/bids described in the Investment Policy? Others boundary restrictions, bond covenants, LOCs 3
Compliance with the Investment Policy Example Policy Language AUTHORIZED INVESTMENTS: (5 ) certificates of deposit issued by a depository institution that has its main office or a branch office in Texas that is: (a ) guaranteed or insured by the Federal Deposit Insurance Corporation or its successor; (b) secured as described in section. (Collateral Section) Watch out for conflicting language in the policy Legal Issues Understanding the legal requirements Public Funds Investment Act (2256.010) Investment Policy Certification Form Public Funds Collateral Act (2257) FIRREA Financial Institution Reform, Recovery Enforcement Act of 1989. http://www.fdic.gov/regulations/laws/rules/1000 1500.html Section e AGREEMENTS AGAINST INTERESTS OF CORPORATION. Bank Contract for CD placement Bank Depository Services Agreement 4
Legal Issues PFIA Public Funds Investment Act: Certificates of Deposit and Share Certificates (2256.010) Issued by a depository institution that has its main office or a branch office in Texas and: (1) guaranteed or insured by the Federal Deposit Insurance Corporation or its successor or the National Credit Union Share Insurance Fund or its successor; (2) secured by obligations that are described by Section 2256.009(a), including mortgage backed securities directly issued by a federal agency or instrumentality that have a market value of not less than the principal amount of the certificates, but excluding those mortgage backed securities of the nature described by Section 2256.009(b); or (3) secured in any other manner and amount provided by law for deposits of the investing entity. Texas entities are allow to invest their funds through Texas banks participating in the CDARS service. (b) Comply with the Investment Policy Certification form requirements (2256.005 (k)) Legal Issues PFIA Public Funds Investment Act: Certificates of Deposit and Share Certificates (2256.010) (1) the funds are invested by an investing entity through: (A) a broker that has its main office or a branch office in this state and is selected from a list adopted by the investing entity as required by Section 2256.025; or (B) a depository institution that has its main office or a branch office in this state and that is selected by the investing entity; (2) the broker or the depository institution selected by the investing entity under Subdivision (1) arranges for the deposit of the funds in certificates of deposit in one or more federally insured depository institutions, wherever located, for the account of the investing entity; (3) the full amount of the principal and accrued interest of each of the certificates of deposit is insured by the United States or an instrumentality of the United States; and (4) the investing entity appoints the depository institution selected by the investing entity under Subdivision (1), an entity described by Section 2257.041(d), or a clearing broker dealer registered with the Securities and Exchange Commission and operating pursuant to Securities and Exchange Commission Rule 15c3 3 (17 C.F.R. Section 240.15c3 3) as custodian for the investing entity with respect to the certificates of deposit issued for the account of the investing entity. 5
Legal Issues CDARS Certificate of Deposit Account Registry Service Main or branch office in Texas $250,000 FDIC Insurance Fixed maturities Appoint depository institution / broker custodian Substantial early withdrawal penalties www.cdars.com Legal Issues Brokered CDs Main or branch office in Texas $250,000 FDIC Insurance The CD must be in your entity s name Do the research and make sure you are comfortable with the transaction process 6
Other FDIC Spread Products Rely on$250,000 FDIC Insurance Where do they fit? Government Security? CDARS like? Financial Institution Deposit? Money Market Demand Accounts Controlled distributions Get a legal opinion Read the Agreements and do your homework Legal Issues Policy Certification Texas Public Funds Investment Act Certification (EXAMPLE) This certification is executed on behalf of Entity Name (the Investor) and (the Seller) pursuant to the Public Funds Investment Act, Chapter 2256.005 (k), Government Code, Texas Codes Annotated (the Act) in connection with investment transactions conducted between the Investor and Dealer. The undersigned Qualified Representative of the Seller hereby certifies on behalf of the Seller that: 1. The Qualified Representative is duly authorized to execute this Certification on behalf of the Seller, and 2. The Qualified Representative has received and reviewed the Investment Policy furnished by the Investor, and 3. The Seller has implemented reasonable procedures and controls in an effort to preclude investment transactions conducted between the Seller and the Investor that are not authorized by the entity's investment policy, except to the extent that this authorization is dependent on an analysis of the makeup of the entity's entire portfolio or requires an interpretation of subjective investment standards. Qualified Representative Signature Name (Printed) Title Date 7
Existing Depository Agreement Research the Bank Depository Agreement for contractual limitation restricting the CD transactions to the bank FDIC FDIC coverage $250,000 Will CD investments (Principle and Interest) be under the FDIC $250,000 limit? $250,000 coverage based on the FDIC definition of political subdivision. http://www.fdic.gov/deposit/deposits/factsheet.html Consider other local units of your municipality when calculating total deposits at your local depository unless: Any non profit corporation, created by the local government is a 501C 3 entity that stands alone Economic Development Corporation, Housing Finance Corporation, Etc TaxID is the FDIC identifier 8
FDIC All time and savings deposits (interest bearing) owned by a public unit and held by the same official custodian in an insured depository institution within the State in which the public unit is located are added together and insured up to $250,000. For the purpose of these rules, the term "savings deposits" includes NOW accounts, money market deposit accounts and other interest bearing checking accounts. Separately, all demand deposits (non interest bearing) owned by a public unit and held by the same official custodian in an insured depository institution within the State in which the public unit is located are added together and insured up to $250,000. FDIC If the depository is headquartered in Texas, the FDIC will provide $250,000 for all interest bearing accounts and an additional $250,000 for non interest bearing accounts. If the depository is headquarters in another state, the FDIC will provide only $250,000 for all accounts regardless of type. 9
Collateral Public Funds Collateral Act (2257) Define acceptable collateral and specific collateral requirements in the Investment Policy If CD investments (P&I) are over the FDIC coverage: What type of collateral is authorized / acceptable? What is the margin required 100% or higher? Where is the collateral held? Federal Reserve, FHLB, other independent source. You need a custody agreement with all but the FED. How is the Market Value determined/reported/verified? Market Value = Par x Market Price Collateral must be held by an independent third party Closely monitor 3 rd party of collateral reports Ensure securities are pledged to your entity by name Collateral Letter of Credit (LOC) FHLB Letter of Credit Used in lieu of collateral pledged to the entity. Each letter of credit has a fixed and defined face value, not subject to market fluctuations or third party monitoring or valuations. Easily and quickly liquidated. Direct obligation of FHLB Limited monitoring by the depositing entity. Eliminates issues related to securities such as prepayments, fluctuating values, maturities, and calculations determining the excess of the required coverage. LOCs are not assets of the depository institution, and therefore, would receive different consideration in a receivership scenario. Courts recognize payments under LOC s as being from property of the issuer (FHLB) and not of the debtor (Your Bank) Collecting on an LOC requires no Court Action 10
FIRREA Financial Institution Reform, Recovery Enforcement Act of 1989. http://www.fdic.gov/regulations/laws/rules/1000 1500.html Agreement must be in writing; Executed by depository institution and depositing entity making the claim contemporaneously with the acquisition of assets, Approved by board of directors or loan committee of the institution, and The agreement has been an official record of the institution continuously since its execution. Establish a FIRREA Agreement with all depositories with which you conduct business FIRREA Safekeeping and Custody Requirements of the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 FIRREA requires that the depository institution s board of directors or a designated committee approves depository agreements. The governmental entity should request a copy of the depository s resolution approving the agreement. The following are examples of FIRREA documentation: Certificate of Secretary of the Board of Directors of. The undersigned being the duly elected Secretary of the Board of Directors ( the Board ) of (the Bank ) hereby certifies that attached hereto is a true and correct copy of a resolution of the Board adopted at a meeting held on, 2010, and such resolution has not been amended, modified, or repealed in any respect, and is in full force and effect on the date hereof. Resolution Granting Certain Corporate Authority to Loan and Discount Committee RESOLVED, the Senior Loan and Discount Committee is hereby granted the corporate authority to approve on behalf of (the Bank ) such security agreements and other agreements related to the deposit of funds in this Bank by any governmental entity as such Senior Loan and Discount Committee shall deem in the best interests of this Bank from time to time. Certificate of Secretary of the Senior Loan and Discount Committee of. The undersigned, being the duly appointed Secretary of the Senior Loan and Discount Committee (the Committee ) of (the Bank ), hereby certifies that: 1. In accordance with the authority granted to it by the Board of Directors of the Bank, on, 2010, the Committee approved the pledge of collateral, as required by the depository contract with the City of Buckstop (the City ), to secure the Bank s obligations with respect to deposits maintained at the Bank by the City. 2. The Committee approval has not been amended, modified, or repealed in any respect, and is in full force and effect on the date hereof; 3. The minutes of the Committee meeting held on, 2009, will be maintained as part of the permanent records of the Bank. 11
Understand the CD investment? A time deposit in a financial institution documented by a certificate that displays: Dollar amount Maturity date Interest rate Frequency / Calculation of Interest Adds diversification Analyze Cash Flows to maximize investment horizon with CD placement. Understand the CD investment? Rates for public fund CDs generally are lower than commercial or consumer rates due to collateral requirements. Substantial paperwork and document execution process for establishment of initial CD depository relationship. Documentation Investment Policy Certification Form Present the local investment policy to the depository Custody Agreement FIRREA Agreement Bank Depository Services Agreement Get legal review of documents 12
CDs As Investment Options Define the terms and conditions in your bid solicitation Establish how the depository will calculate interest earnings and how interest will be paid or reinvested. Compare rates to similar investment options. Use CDs and an investment option consideration Amount, rate, maturity, diversification CDs Rates There is a wide variance in rates determined by the bank needs/cash flows and local relationship. Quoted rates are typically simple interest (APR) When comparing the interest rates of CDs, it is important to understand the difference between Annual Percentage Yield (APY) and Annual Percentage Rate (APR). APY is the total amount of interest the CD will earn in one year, taking interest reinvestment into account. APR is the stated interest earned in one year, without taking compounding into account. 13
CDs Interest Reinvestment Many entities do not reinvest the interest when it is calculated. Instead, they receive regular interest checks or DDA credit from the bank providing a periodic income stream for needed cash flows. Not reinvesting the money into the CD account has the downside of reducing the overall yield through compounding. You maximize return by reinvesting the interest each time it is calculated so the interest (APR) will compound (APY). CDs Solicitation Form 14
CDs Solicitation Analysis CD Solicitation Results Bank A Bank B Bank C Bank D Bank D Bank E Bank F Bank G Bank H Bank I Agency Securities Days Pass 90 0.250% 0.280% 0.180% 0.550% 0.600% 0.150% 0.460% 0.650% 0.250% 120 0.250% 0.320% 0.250% 0.550% 0.650% 0.180% 0.460% 0.650% 0.270% 150 0.750% 180 0.500% 0.450% 0.390% 1.000% 0.850% 0.450% 0.200% 0.560% 0.750% 0.300% 270 0.700% 0.550% 0.550% 1.000% 1.000% 0.600% 0.280% 0.560% 0.750% 0.330% Pool A 0.180% Pool B 0.200% CDARS LOC Securities LOC Securities Securities Securities Securities <250,000 CDs Penalty Fees Penalty fees usually keep investors from withdrawing money from the account before the agreed upon maturity date. How much are the penalty fees? The federal government, which insures many CD accounts, has required a penalty of at least seven days' worth of simple interest on money withdrawn six days or less after the initial deposit. Beyond this minimum, CD issuers are free to set their own penalty limits, and the penalties can be substantial. 15
CDs Closing a CD Usually a bank will request the authorization to close the CD in writing. At this point, the customer will instruct the bank how to handle the proceeds, (credit a DDA, wire transfer). Interest should be calculated until the maturity date. CDs Example Transaction Form Bank: Current Date: / / Settlement Date: / / Maturity Date: / / Amount ($):.00 Term in days: Interest Rate (%):. % Rate Scale Included: Y / N Calculated Int. ($):. Quote Valid Through: / / FDIC $250,000 Coverage: Y / N LOC: Y / N LOC Amount: $ Additional Collateral: Safekeeping Location and Contact Information: Investment Policy Received? Investment Policy Certification Form Completed? Bank Depository Services Agreement? Custody Agreement? FIRREA Agreement Completed? Y / N Y / N Y / N Y / N Y / N Authorized Bank Contact: Bank Contact information: 16
Methods, Terms & Conditions Where are we going to buy the CDs? Local depository, other local banks, Texas banks Confirm that your Depository Contract allows for CDs to be purchased outside of the local depository. Do I have contacts for the authorized persons at the depositories to respond to my bids? You should have a Bank Depository Services Agreement for CD placement What are the terms and conditions on structuring bids? Investment timeline, maturity needs, collateral requirements, and Investment Policy considerations? Methods, Terms & Conditions Methods to solicit and evaluate bids How are we going to compare Apples to Apples? Rates, Interest earnings Reinvested / transferred, Collateralization, Reporting How will we accept quotes (Written, email)? How long are the quotes valid to settlement? Can I create a form that can be used for solicitation? Document results of solicitation Notification to accept or decline Response to unsuccessful bidders Decision to disclose placement results 17
Establishing a Checklist Allowed by Investment Policy? Allowed by existing Depository Contract? Bid solicitation process in conformance with the Investment Policy requirements? Investment Policy Certification form received? Ethics disclosure 2256.005? FIRREA documents received? Custody agreement received? Letter of Credit established? Bank Depository Services Agreement established? CD documents from bank reviewed? Additional Thoughts Set maturity dates on a good business date Select the option for non automatic renewal at maturity For CDARS: Maturities set with amount limitations Rates offered can vary by originating bank Not all CDARS member banks accept deposits Choose Reciprocal Option on CDARS Deposit Placement Agreement Include all other non CDARS financial institutions for deposit bank exclusion Fixed placement / settlement timeline 18
Additional Thoughts Potential ethics disclosure statements 2256.005 (i) personal business relationship, relationship by blood or by marriage GASB Statement No. 40 Update of GASB Statement No. 3 Custodial risk Disclose non third party custodial arrangements for collateral Additional Thoughts If a LOC used, set the termination date several days beyond the CD maturity date A Faxed LOC copy is acceptable to settle; with the hard copy original from FHLB There are different types of LOC, know the difference LOC s will differ by issuing FHLB locations for the same type (Atlanta vs. Dallas) Language for the same type of LOC should not be assumed to always be identical 19
Additional Thoughts Quoted rates for the same maturity can vary dramatically between banks Bank appetite for funds can vary significantly between solicitations Suggest always including the primary depository bank in the quote solicitation process Conclusion CDs are typically a safe traditional investment A federally insured bank CD provides $250,000 in FDIC coverage per Tax ID CDs are available in a variety of configurations Careful preparation is essential to start Cash Flow monitoring is key to CD investments Understand your local Investment Policy and the additional documentation requirements Examining the terms / conditions / investment needs and documentation is the key to an effective CD investment strategy 20