Objectives of Cash Management

Cash management may be defined as all activities undertaken to ensure maximum cash

availability and maximum investment yield on a government's idle cash. Cash management is

concerned with the efficient management of cash from the time revenue is earned to the time a

check or disbursement clears the bank.

Cash management activities include the following functions:

1) Receipt and deposit of cash and negotiable payments

2) Physical custody of monies and securities

3) Disbursements of funds upon proper authorization

4) Investing excess cash

5) Cash budgeting and forecasting

6) Short-term borrowing

7) Cash reporting

In its simplest form, the cash management function has three elements:

1) Cash mobilization: get the cash in as quickly as possible.

2) Controlled disbursement: release cash at the last possible moment.

3) Investment program: make the cash work in the meantime.

The constraints under which a cash manager must operate and the inherent conflicts between

investment yield and risk dictate that the cash manager strive to meet the following subsidiary

objectives as well.

1) The cash management system should support the operations of the government.

2) The cash management system must protect the assets of the government at all times.

3) The cash management system must provide adequate liquidity to meet all expected

and unexpected obligations.

4) The cash management system must be well-documented and accountable.

In recent years, cash management has grown in importance and is considered a key element of

the financial management process. Establishing and maintaining a cash management system that

maximizes both availability of cash and investment yield is a task that challenges financial

managers in all governments.

Controls and Organization for Government

Because of the risk inherent in handling cash and investments, internal controls are an important

consideration. An adequate internal control environment is essential for the reliability of

financial statements.

While the configuration of an internal control environment varies widely, internal controls are

established to meet five objectives.

1. To provide reliable data for management. Transactions that represent economic events

are recorded in accordance with prescribed procedures in the right accounts in the correct

amounts on a timely basis.

2. To safeguard assets and records. Access to assets and related documentation should be

restricted to authorized personnel. Furthermore, the accounting records are maintained so

that they continue to reflect the operation of the government.

3. To establish accountability. Responsibility for assets and other resources should be well

defined. Timely verification and follow-up procedures are essential.

4. To promote operational efficiency. Internal controls should reduce unnecessary

duplication of effort and deter inefficient use of government resources.

5. To facilitate financial reports. The system should assure that transactions are recorded to

permit preparation of financial statements in conformity with generally accepted

accounting principles (GAAP).

Internal controls need only provide reasonable, not absolute, assurance that these objectives will

be accomplished. Guarantee of these goals is probably impossible and is usually financially

unsound in smaller governments since they may lack the resources to provide for the necessary

increased division of responsibilities among staff. Augmented internal controls come at a cost,

and that cost should not exceed the benefits expected to be derived. Good internal control

procedures can help to reduce audit fees by allowing the auditors to rely on those controls,

thereby permitting a reduction in the extent of their audit tests.

The control environment in an organization permeates all aspects of operations, not just the

finance function. One of the most important elements of the control environment is personnel

policies and procedures. To ensure a good internal control system, management must hire

competent personnel with integrity and then train them so that they understand their duties.

The segregation of functions is one of the most powerful aspects of internal control. The

overriding principle is no one person should ever be placed in a situation to carry out or conceal

an error or irregularity without timely detection by others in the normal course of carrying out

their responsibilities.

Recommended Internal Control Practices

Authorizations:

Develop procedures and policies to specify how the department will comply with the

organization’s objectives and departmental expectations.

Supervisors and Managers should verify cash deposits, voided transactions, and overages

and shortages.

Segregation of Duties:

Establish a chain of custody and accountability immediately upon initial receipt of funds.

Individual accountability should be maintained at all times. Transfers of custody

between individuals should be jointly verified and documented.

Cashiers should prepare independent records of receipts and maintain individual cash

drawers.

Different employees should be responsible for:

– Receiving and recording collections of deposits.

– Balancing and reconciling daily deposits to departmental recordings.

– Verifying the deposit amounts reflect correctly in the general ledger and

departmental reporting.

Safeguarding:

Separate lockable cash drawers should be available to all individuals collecting money.

Checks should be restrictively endorsed upon receipt.

Cash counting areas should be secured and free from interruptions.

If deposits must be kept overnight, they must be kept in a safe or locked location.

Deposits should be deposited in the bank daily.

Safe combinations should be changed regularly.

Recording and Depositing:

Deposits should be presented intact.

All cash receipts should be recorded on a cash receipt form, cash register, or a properly

controlled computer system at the time of receipt.

Checks should be made payable to the organization.

Reconciliation and Review:

All receipt numbers should be accounted for.

All detailed organizational records should match the bank deposit records.

Cash Accounting and Reporting Systems

The ability to maintain an adequate cash flow and properly invest available cash is the most

important function of a cash manager. Cash reporting systems facilitate the performance of this

function and have the following components, each of which interact and rely on the other:

1) a cash accounting system;

2) an investment and interest apportionment accounting system; and

3) a reporting system of cash and investments consisting of bank reconciliations and

treasurer's reports.

The Cash Accounting System

The cash accounting system is required to maintain the daily receipts and disbursements that

occur in all jurisdictions. These activities are maintained by fund and account designation, and

the resulting data are used to provide information for management. The cash accounting system

is the foundation on which all other systems are built. A good cash accounting system does five

things:

1) provides accurate and current data, resulting in improved controls over cash invested and

balances in bank accounts;

2) allows interest to be allocated by fund based on daily cash balances;

3) permits comparison of budgeted with actual cash on hand;

4) provides some of the information needed to perform reconciliations;

5) supplies the cash balance information required to invest available cash in compliance

with investment guidelines.

Accounting for Investments and Interest

In fund accounting, each fund has its own cash account. In the past, treasurers maintained

separate checking accounts that corresponded with these separate cash fund balances. This

method can be very cumbersome. For example, a temporary overdraft in one account would have

to be covered by a transfer from another account with excess funds. Moreover, with several

accounts, bank service fees are higher because of the difficulty of maintaining a minimum

compensating balance in each account.

A more modern approach is to pool all cash, regardless of fund classification, into one bank

account. Not only can this reduce bank service charges, it also facilitates the investing of idle

cash funds by centralizing all banking activity into one account. This enables the cash manager

to more easily identify cash resources and match them with current and anticipated demands on

cash.

Apportionment of Interest.

Pooling has no effect on the segregation of cash by fund for accounting purposes, interest

allocation and reporting. Of course, pooling cash in this manner makes reconciling the bank

balance more difficult when compared to the individual account approach, but this

inconvenience is more than offset by the aforementioned gains.

The pooling method produces complications in bank reconciliation in that interest earned is no

longer income to a particular fund but rather results from the pooling of cash of all funds. An

interest allocation system must be established to properly credit individual funds for the pro rata

share of the interest earnings.

Reconciliation Reports: Purposes and Procedures

A good accounting system produces accurate and timely records of cash on hand and cash

investments. Various types of reconciliations are useful for maintaining proper control over cash:

bank reconciliations, proofs of cash, and various treasurer's reports.

A bank reconciliation is a schedule indicating and explaining differences between the bank's

record of a government cash account and the government's record. The general form of a bank

reconciliation is known as a bank to books reconciliation, since it starts with the balance obtained

from a bank statement as of a certain date and ends with the book cash balance on that same date.

A second type of control schedule is a four-column reconciliation, known as a proof of cash.

This statement reconciles an entire month's activity.

A treasurer's reconciliation report is used to track daily activity in each accounting cash fund and

every cash and investment account owned by the government. Many states, including Texas,

require an investment report that lists all investments monthly or quarterly as well as an annual

position statement on investment policy.

External documents are needed to reconcile bank accounts and to calculate resultant journal

entries. These consist of bank statements from the jurisdiction's servicing bank; confirmations

from dealers, brokers or institutions verifying the purchase, maturity or interest instruments; and

safekeeping receipts and trust department safekeeping reports.

Financial Reporting for Deposits and Investments

The basic disclosure requirements of GASB Statement No. 3 have been replaced with GASB 40.

Summary of Statement No. 40 Deposit and Investment Risk Disclosures—an amendment of

GASB Statement No. 3 (Issued 3/03)

The deposits and investments of state and local governments are exposed to risks that have the

potential to result in losses. This Statement addresses common deposit and investment risks

related to credit risk, concentration of credit risk, interest rate risk, and foreign currency risk. As

an element of interest rate risk, this Statement requires certain disclosures of investments that

have fair values that are highly sensitive to changes in interest rates. Deposit and investment

policies related to the risks identified in this Statement also should be disclosed.

Types of Banking Services

The first step in selecting the best mix of financial services is to define the available services.

They include:

1) collection services;

2) disbursement services;

3) investment services; and

4) credit services.

Collection Services

Collection services have the objective of accelerating the rate at which receivables become

available for investment. This is achieved by reducing collection float, which refers to the normal

processing of cash receipts through the mail and the government's internal procedures for

recording, reconciling, and investing collections. By utilizing various collection services, a

government can increase funds available for investment purposes. Electronic wire transfers and

lock box systems are two popular services used by local governments.

Governments collect revenue in five ways:

1) payment for services;

2) tax payments dictated by law;

3) miscellaneous fees and charges;

4) fines and court costs; and

5) grants from state and federal sources.

Payment for service is generally made upon delivery of the service or after the service is

provided. Compared to the other three types of collections, payments for services require a large

investment in staff time and effort, to prepare billings, maintain records, process payments and

collect past due amounts. One typical problem that governments face is the cyclical nature of

activity surrounding billing and processing. Cycle billing can alleviate the alternate periods of

high and low activity level. Under such a system, a portion of the billing is completed each week

during the month or accounting period, thus spreading the workload evenly through the period.

The interval of time between billing and the deposit of payments into a bank account is known as

float. There are three types of float that need to be managed (minimized). The first is mail float,

or the time a payment is in the mail system before the government has possession of the check.

This can be minimized by using post office boxes for payments so that they do not have to be

sorted from other mail. Collecting checks periodically (even several times each day) from these

boxes will minimize the time before staff processes payments.

Administrative float is the time needed to process the payment. Collection float is the time

necessary to get funds deposited into a bank account. One of the most useful methods of

minimizing float is the lock box. A lock box is a post office box used solely for payments. Bank

personnel are authorized by the government to collect the payments for immediate processing.

The cost of this service must be considered and compared to the savings that result from timely

deposit of funds. Arrangements should be made with the bank for processing checks not

accompanied by payment slips and those that do not match the payment due amount.

Disbursement Services

Disbursement services have the primary objectives of decelerating cash disbursements by

lengthening the disbursement float and minimizing idle cash held in a non-interest bearing bank

account. Techniques and communication methods range from a daily phone call to the more

complicated concentration/zero balance account structure.

The concentration/zero balance structure consists of a main bank account (concentration

account) that contains the government’s funds. The zero balance accounts are used for

disbursement with funds transferred each day from the concentration account to cover disbursed

amounts. Having all funds in a single account allows greater investment opportunity and

eliminates the need to determine how much to have deposited in multiple accounts. The

concentration account provides the compensating balance that pays for banking services.

Wire and automated clearing house transfer technology allows governments to delay payments

until the due date. This maximizes terms of payments for purchases and contractual obligations.

Of course, payors making payments to governments are also taking advantage of this technology.

Investment and Credit Services

Investment services and specific investment techniques are available to governments to assist

them in their investment programs. Investment services offered by a bank will depend on a

bank's location and size, and may include the offering of several money market instruments,

including certificates of deposit; investment advice; traditional time deposits; and, pension fund

investment advice as well as safekeeping and custody services. Credit services are available to

governments that borrow money for short- or long-term purposes. Services can range from direct

loans (subject to statutory limitations) to support functions relating to paying agent and registrar

on a government's bond issue to participation in local community or economic development

projects.

Typical Cash Management Services

Account Reconcilement Services: Balancing a checkbook can be a difficult process for

large entities. It can take a lot of human monitoring to understand which checks have not

cleared and therefore what the current account balances are. Banks have developed a

system which allows companies to upload a list of all the checks that they issue on a daily

basis, so that at the end of the month the bank statement will show not only which checks

have cleared, but also which have not. In addition, banks have used this system to

prevent checks from being fraudulently cashed if they are not on the list, a process known

as positive pay.

Advanced Web Services: Most banks have Internet-based systems. This enables

managers to create and authorize special internal logon credentials, allowing employees

to send wires and access other cash management features remotely and quickly.

Armored Car Services (Cash Collection Services): Large entities who collect a great

deal of cash and collections may have the bank pick up these deposits via an armored car

company, instead of asking its employees or staff to make trips to the bank.

Automated Clearing House: An electronic system used to transfer funds between banks.

Entities use this to pay others, such as employee’s payroll (this is how direct deposit

works). Certain entities also use it to collect funds from customers (this is generally how

automatic payment plans work). This system is criticized by some consumers, because

under this system banks assume that the company initiating the debit (payment) is correct

until proven otherwise.

Balance Reporting Services: Entities who actively manage their cash balances usually

subscribe to secure web-based reporting of their account and transaction information at

their lead bank. They include information on cash positions as well as 'float' (e.g., checks

in the process of collection). Finally, they offer transaction-specific details on all forms of

payment activity, including deposits, checks, wire transfers, ACH (automated

clearinghouse debits and credits), investments, etc.

Cash Concentration Services: Entities open bank accounts at various local banks in the

area. To prevent funds in these accounts from being idle and not earning sufficient

interest, entities have an agreement set with their primary bank, whereby their primary

bank uses the Automated Clearing House to electronically "pull" the money from these

banks into a single interest-bearing bank account.

Lockbox: Entities which receive a large number of payments via checks in the mail have

the bank set up a post office box for them, open their mail, and deposit any checks

deposited. This is referred to as a "lockbox" service.

Positive Pay: Positive pay is a service whereby the entity electronically shares its check

register of all written checks with the bank. The bank therefore will only pay checks

listed in that register, with exactly the same specifications as listed in the register

(amount, payee, serial number, etc.). This system dramatically reduces check fraud.

Reverse Positive Pay: Reverse positive pay is similar to positive pay, but the process is

reversed, with the entity, not the bank, maintaining the list of checks issued. When checks

are presented for payment and clear through the Federal Reserve System, the Federal

Reserve prepares a file of the checks' account numbers, serial numbers, and dollar

amounts and sends the file to the bank. In reverse positive pay, the bank sends that file to

the company, where the company compares the information to its internal records. The

company lets the bank know which checks match its internal information, and the bank

pays those items. The bank then researches the checks that do not match, corrects any

misreads or encoding errors, and determines if any items are fraudulent. The bank pays

only "true" exceptions, that is, those that can be reconciled with the company's files.

Sweep accounts: Typically offered by the cash management division of a bank. Under

this system, excess funds from a company's bank accounts are automatically moved into

a money market mutual fund overnight, and then moved back the next morning. This

allows them to earn interest overnight. This is the primary use of money market mutual

funds.

Zero Balance Accounting: Entities with large numbers of locations can very often be

confused if all those locations are depositing into a single bank account. Traditionally, it

would be impossible to know which deposits were from which locations without seeking

to view images of those deposits. To help correct this problem, banks developed a system

where each location is given their own bank account, but all the money deposited into the

individual store accounts are automatically moved or swept into the entity’s main bank

account. This allows the entity to look at individual statements for each location. U.S.

banks are almost all converting their systems so that entities can tell which location

made a particular deposit, even if these deposits are all deposited into a single account.

Therefore, zero balance accounting is being used less frequently.

Wire Transfer: A wire transfer is an electronic transfer of funds. Wire transfers can be

done by a simple bank account transfer, or by a transfer of cash at a cash office. Bank

wire transfers are often the most expedient method for transferring funds between bank

accounts. A bank wire transfer is a message to the receiving bank requesting them to

effect payment in accordance with the instructions given. The message also includes

settlement instructions. The actual wire transfer itself is virtually instantaneous, requiring

no longer for transmission than a telephone call.

Controlled Disbursement: This is another product offered by banks under Cash

Management Services. The bank provides a daily report, typically early in the day, that

provides the amount of disbursements that will be charged to the customer's account.

This early knowledge of daily funds requirement allows the customer to invest any

surplus in intraday investment opportunities, typically money market investments. This is

different from delayed disbursements, where payments are issued through a remote

branch of a bank and customer is able to delay the payment due to increased float time.

Cash management services can be costly but usually the cost to an entity is outweighed by the

benefits: cost savings, accuracy, efficiencies, etc.

Obtaining Banking Services

Competitive bidding for banking services with competition among banks is recommended and

may be legally required. Competitive bidding usually will prove beneficial to government units.

Benefits that can be obtained through competition are:

1) additional interest earnings resulting from improved yields if investments are divorced

from routine banking services;

2) additional interest earnings resulting from an overall increase in amounts available for

investment through better use of a bank's collection services;

3) additional bank services available for the same service charges or compensating balances;

4) reduced bank service charges or compensating balances;

5) increased efficiency in cash management operations.

Competitive selection can be achieved through a written request for application (RFA) for

banking services. The RFA format can be flexible but should include requests for information to

facilitate the evaluation of facilities and specifications of depository and investment services

needed. The format of the RFA should allow the responding institutions a chance to describe

their services, costs and credit worthiness. Development of the RFA should include a review of

legal requirements for the selection of banking services. Some statutes specify the maximum

contract length, define the selection process, and may even name the basis for contract award.

FDIC Deposit Insurance for Accounts held by Government

Depositors (Date Sensitive Information)

http://www.fdic.gov/deposit/deposits/FactSheet.html

Section 330.15 of the FDIC’s regulations (12 C.F.R. 330.15) governs the insurance coverage of

public unit accounts. For deposit insurance purposes, the term "public unit" includes a state,

county, municipality, or "political subdivision" thereof. Under section 330.15, the "official

custodian" of the funds belonging to the public unit – rather than the public unit itself – is

insured as the depositor.

Permanent Rule The insurance coverage of public unit accounts depends upon the type of

deposit and the location of the insured depository institution.

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.

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.

For the purpose of these rules, the term ‘savings deposits’ includes NOW accounts, money

market deposit accounts and interest bearing demand deposit accounts. The term ‘demand

deposits’ means deposits payable on demand and for which the depository institution does not

reserve the right to require advance notice of an intended withdrawal.

The insurance coverage of accounts held by government depositors is different if the depository

institution is located outside the State in which the public unit is located.

In that case, all deposits owned by the public unit and held by the same official custodian

are added together and insured up to $250,000.

Time and savings deposits are not insured separately from demand deposits.

As mentioned above, a political subdivision (through its official custodian) is entitled to its own

insurance coverage. The term "political subdivision" is defined to include drainage, irrigation,

navigation, improvement, levee, sanitary, school or power districts, and bridge or port authorities

and other special districts created by state statute or compacts between the states. The term

"political subdivision" also includes any subdivision or principal department of a public unit

(state, county, or municipality) if the subdivision or department meets the following tests:

The creation of the subdivision or department has been expressly authorized by the law of

such public unit;

Some functions of government have been delegated to the subdivision or department by

such law; and

The subdivision or department is empowered to exercise exclusive control over funds for

its exclusive use.

The term "political subdivision" does not include subordinated or non-autonomous divisions,

agencies, or boards within subdivisions or principal departments.

Again, a public unit (including a political subdivision) is insured through its official custodian. If

the same individual is an official custodian for more than one public unit, he or she is separately

insured for the deposits belonging to each public unit. On the other hand, two or more

individuals are treated as one official custodian if action or consent by all of these individuals is

required for the exercise of control over the funds of a single public unit.

An official custodian is an officer, employee, or agent of a public unit having official custody of

public funds and lawfully depositing the funds in an insured institution. In order to qualify as an

official custodian, a person must have plenary authority – including control – over the funds.

Control of public funds includes possession as well as the authority to establish accounts in

insured depository institutions and to make deposits, withdrawals and disbursements.

Deposit insurance coverage cannot be increased by dividing funds among several putative

official custodians who lack plenary authority over such funds. Likewise, coverage cannot be

increased by dividing funds among several accounts controlled by the same official custodian for

the same public unit.

Special Rule for Public Bonds A special rule applies to funds held by an officer, agent or

employee of a public unit under a law or bond indenture that requires the funds to be set aside to

discharge a debt owed to the holders of notes or bonds issued by the public unit. A deposit of

such funds in an insured depository institution is insured up to $250,000 for the beneficial

interest of each bondholder. This coverage is separate from the coverage for other deposits

owned by the public unit at the same institution. In order to obtain this special coverage,

however, the deposit account must satisfy certain disclosure requirements applicable to deposits

held by agents or fiduciaries. Specifically, the deposit account records of the insured depository

institution must disclose the existence of the fiduciary relationship or the fiduciary nature of the

deposit. In addition, the details of the fiduciary relationship and the interests of the bondholders

must be ascertainable from the records of the depository institution or the records of the

depositor maintained in good faith and in the regular course of business. See 12 C.F.R. 330.5(b).

The relevant section of the FDIC's deposit insurance regulations can be found at: 12 C.F.R.

330.15. If you have questions or comments about the insurance coverage of public unit

accounts, contact the Federal Deposit Insurance Corporation by telephone at 1‐ 877‐ASK‐FDIC

or by mail at 550 17th Street, NW, Washington, DC 20429.

Cash Forecasting

Cash forecasts are projections of anticipated receipts, disbursements, and cash balances over a

certain period of time, typically a year. Accurate cash forecasting is an important cash

management tool because it can:

1) improve investment earnings by forecasting the amount of cash that will be available for

investment, and for what time period;

2) identify temporary cash deficits that require short-term debt financing and ensure

compliance with federal arbitrage regulations;

3) ensure liquidity by providing estimates of the amount of cash on hand for timely

disbursements;

4) enhance creditworthiness through improved cash management practices, thereby

reducing the cost of borrowing to debt issuers; and

5) warn of impending problems with the annual fiscal budget through the identification of

potential revenue shortfalls or unexpectedly large disbursements that could result in cash

deficits.

There are several types of cash forecasts as follows.

1) Annual cash forecasts provide monthly estimates of cash position, including the level of

positive and negative cash balances. They are useful in determining the amount of cash

available for investment in instruments with maturities of 30 days or more.

2) Monthly cash forecasts provide weekly estimates of cash position. They can be used to

monitor the accuracy of the annual forecast and are useful in making decisions involving

investment instruments in the 0-90 day range.

3) Weekly cash forecasts provide daily estimates of cash position. They can be used to

monitor the accuracy of the monthly forecast and can be used for investment decision

making involving instruments with maturities of fewer than seven days.

While the main objective of each type is to forecast cash position at some future point in time,

each has different purposes, benefits and costs. Approaches to cash forecasting range from the

informal to the sophisticated. At a minimum, investment officers should coordinate banking

services that assist in the development and reporting of cash forecasts as well as utilizing

spreadsheet and databases applications to automate much of the forecasting process.

Investment Policies and Strategies

Governments should have and, in some states such as Texas1, may be required by law to have a

written investment policy. A formal policy protects not only the assets of the organization (which

belong to the public), but also the elected official and management staff. The three objectives

that should direct any investment policy are:

Safety

Liquidity

Yield.

Safety is listed first. Because public investment officials have a fiduciary responsibility with

regard to the monies that they manage, safety, or the preservation of capital, must be their

primary concern. Treasurers must manage investments in such a way as to minimize risk. The

various types of risk that require attention are described below.

1) Credit Risk – risk that the issuer of a security may default. Credit risk is gauged by

quality rating assigned by commercial rating companies, such as Moody’s Investors

Services, Standard and Poor’s, and Dominion Bond Rating Service.

2) Liquidity Risk – involves the ease at which the security can be sold. In an active

secondary market for a security-type, there are always buyers available. One key to the

secondary market activity is the spread between the bid price and the offer price. In active

markets, such as Treasury Bills, the difference in the bid and offer may only be a basis

point or two. For inactive markets, the spread may be several basis points.

3) Market Risk – the price of the typical security will move in the opposite direction of

interest rates. As interest rates rise (fall), the price of a fixed income security will rally

(rise). For an investor who plans to hold a fixed income security to maturity, the change

in its price prior to maturity is not of concern; however, for an investor who may need to

sell the security prior to maturity, an increase in interest rates will mean the realization of

a capital loss.

4) Volatility Risk – risk that the price of a security will be more violently affected by

changes in interest rates. Certain attributes of a security, such as a long-term maturity

date, an embedded option (such as a call feature), will cause the security to exaggerate

the effects of market changes. For example, when interest rates increase slightly, a

Treasury Bill will be affected only slightly. In the same environment, a mortgage-backed

security’s value may plummet.

5) Extension Risk – risk that a change in interest rates will cause the anticipated maturity of

a security to extend. An example would be a mortgage-backed security that has been

historically paying off faster than the absolute maturity date of the issue as homeowners

refinance, upgrade, etc. In such a case, investors typically assume this accelerated

payment will continue and will calculate the “average life” of the investment to be shorter

that the absolute. When interest rates rise, however, homeowners may cease to refinance,

upgrade, etc. and the average life of the security will return to the absolute maturity date.

6) Re-investment Risk – risk that the cash flows generated by a security will be reinvested

at a lower rate than the prevailing interest rate levels. This risk becomes a much more

critical consideration for callable securities. If an issuer holds the right to call the security

when interest rates fall, the investor is faced with having to reinvest the proceeds in a

lower rate environment.

7) Collateral Risk – risk that the market value of the collateral an investor receives against

his investment will not be adequate to cover the investment plus interest accrual in the

case of a counterparty default. It can also be applied to the degree of “perfected interest”

that the investor contractually holds in ownership of the security. For example, the

collateral should be held at a third party institution in the account name of the investor.

Repurchase agreements should always be governed by an executed PSA Master

Repurchase Agreement between the investor and the dealer.

8) Event Risk – risk that an unforeseen event or accident could negatively affect the value

of a security. An example would be the Orange County bankruptcy and the impact that

this had on the participants in the investment pool managed by that county. Not only were

the participants’ funds withheld, but their credit ratings were adversely affected by their

lack of liquidity. Investors who held bonds issued by these governments saw the value of

their securities decline.

The key is to remember that all the various risks are ongoing all the time and to determine the

acceptable level of risk and to ensure that the risks are monitored on an ongoing basis.

Liquidity, the speed with which an investment can be converted to cash, is also important.

Invested funds must be available when the government needs to make expenditures.

Yield, or the rate of return -- the income which is derived from investments -- is the third

objective. While additional income from investments is important, it must never become the

prime consideration in the investment of public funds and must be tempered by acceptable risk.

The investment policy may include specific reference to the prudent investor rule, which states

that persons should exercise the same level of care in managing the funds of others that they

would with their own funds.

Once policy is developed, it should be presented to the governing board for adoption by

ordinance or resolution. The policy should be implemented immediately and procedures

developed using the policy as a framework. The policy also can be used to monitor actual

investment activity. The policy and the strategy statements (discussed below) should be reviewed

at least annually and updated to include new investment legislation, personnel changes or other

issues that may arise.

Investment Strategies

The investment policy establishes the goals and objectives of the entity’s investment

management program. The investment strategy is the plan designed to achieve the goals and

objectives. The foundation of the plan is the entity’s cash forecast. Cash flow needs determine

investment selection by types and maturity. Whether the investment portfolio is large or small, or

whether the portfolio is managed internally or externally, a cash forecast will be required.

Written investment strategies in the investment policy must address:

(1) Suitability

(2) Preservation and safety of principal

(3) Liquidity

(4) Marketability

(5) Diversification

(6) Yield

With the cash forecast as the base, investment strategies should focus on safety of principal,

liquidity to meet unforeseen cash needs, suitability of the investment, and diversification of the

portfolio as a means to control risk, and finally yield. Investment suitability includes

consideration of management’s tolerance for risk, staff resources and time devoted to investment

management. For example, the cash forecast may indicate that an entity may safely invest a

portion of its investment portfolio for twelve months but may not have access to the market

information required to monitor the value of all security types available at this maturity. Staff

resources and time will also influence how actively the portfolio is managed.

Public investment officials should review their investment capabilities, constraints and objectives

to decide which investment strategy works best for them. In the final analysis, cash managers

should remember the "SLY" priority of investment objectives: safety and liquidity always come

before yield.

Investment Economics

A key concept for investment planning is the yield curve--the relationship between interest rates

and the time to maturity on investments. A yield curve is simply a graph plotting the yields on a

specified security (e.g. Treasury bills or bank certificates of deposit) on the vertical axis, with the

maturity of each instrument on the horizontal axis. Each point on the yield curve represents the

yield for a particular maturity of a security.

So what determines the shape of the yield curve? Most economists agree that two major factors

affect the slope of the yield curve: investors’ expectations of future interest rates and certain

“risk premiums” that investors require to hold longer maturity investments. Yield curves take

many shapes and do not remain stable. Most of the time,

the yield curve rises from the left to the right, as interest

rates are higher on longer-term maturities. Such an

upsweeping or ascending yield curve is called a normal

yield curve.

In periods of high interest rates usually associated with

periods of tight money, the yield curve may invert. When

this happens, short-term rates exceed long-term rates. This configuration reflects investors'

expectations that high interest rates will not last forever, and a slowdown will probably drive

interest rates lower. Such a downward sloping yield curve is called an inverted yield curve.

An inverted yield curve is often a foreshadow of a recessionary period. A positively sloped yield

curve often foreshadows inflationary growth.

The yield curve should be a smooth continuous line that flattens out

as maturities lengthen. Whenever a specific security lies above the

rest of the curve, it may represent a buying opportunity. Similarly,

when a security held in a portfolio lies below the curve, it may be

prudent to sell it.

Experienced public investors learn to study the yield curve and find

maturities that offer the best relative value. With flat yield curves

the general rule is to select shorter maturities; with steep curves,

longer maturities may offer better investment values.

Closely linked with analysis of the yield curve is the design of a government's portfolio. Of

particular concern should be the development of a policy of diversification to minimize risk. The

most common way that this is achieved is through limits on investments by type, maturity, and

financial institution.

Investment Instruments

The investment process involves systematic selection of securities and investment instruments

that meet a local government’s objectives and constraints. Investment instruments should always

be analyzed in the context of four criteria: legality, safety, liquidity and yield. Major forms of

investment instruments are as follows and are detailed in the Public Funds Investment Act of

Texas:

U.S. Treasury Bills (T-bills). These short-term obligations are issued at a discount from their

par maturity value. T-bills are considered risk free and very liquid instruments with the highest

degree of marketability. Their yields tend to be the lowest of all money market instruments.

Unsecured obligations of the U.S. Government.

Maturity of a year or less when issued.

Unlike longer-term Treasuries, T-Bills pay no coupons.

They make a single payment of par value at maturity.

They are issued at a discount to par, so an investor who holds a T-Bill to maturity earns

the difference between the par value and discounted value at which the instrument was

purchased.

Prices for T-Bills are quoted for USD 100 of par value.

T-Bills are also quoted as an actual/360 discount yield

The Department of Treasury auctions standard maturities of T-bills.

– These typically include 13, 26 and 52 week maturities.

– All T-bills mature on a Thursday (unless a holiday).

– Certain maturities may be suspended for periods of time.

– These instruments are issued through weekly auctions.

There is an active secondary market for T-bills.

Mechanics

– If you buy/sell, you will be quoted a dollar price as a bid and asked spread

• The bid is the dollar price at which the organization will buy your T-bill if

you are selling

• The asked is the dollar price at which it will sell if you want to buy

• The difference is the spread and it is the profit.

– Price = $10,000 – ($10,000 x asked discount x days to maturity) / 360

Treasury Notes and Bonds. In addition to the Treasury bill series, the U.S. Government also

issues coupon securities called notes and bonds. These instruments pay interest every six months

just like municipal bonds. Unlike Treasury bills, which are quoted on a discount basis, Treasury

bonds and notes are traded in the bond market with prices based on par equaling 100.

Have initial maturities greater than a year.

All pay semi-annual coupons, usually according to a schedule under which coupons are

paid on anniversaries of the security's first issuance date.

Calculate on Actual/Actual basis

Notes and bonds differ only in their initial maturities.

– Notes are issued with maturities up to ten years.

• 2, 3, 5 and 10 year notes

– Bonds have initial maturities greater than ten years.

• 15, 20, and 30 year bonds

By convention, note and bond prices are quoted based on a USD 100 par value.

– Prices can be confusing and expressed in decimal or hyphen form.

• For example USD 101.34 or 101.25 or 101-14.

– Quoting prices in 32nds of a USD is widely used.

• If a bond is quoted at 101-14, this means that the bond's price is 101 and

14/32, or USD 101.4375 per USD 100 of par value.

• A 64th can be added to the price with a plus sign, so 101-14+ means 101

and 14/32 and 1/64.

• Eighths of a 32nd can be added to the price by appending an additional

digit to the quote. For example, 101-143 indicates a price of 101 and 14/32

and 3/256.

• Often, a period replaces the hyphen in this notation, so don't assume that a

quote of 101.25 means 101 and 1/4 USD. It very likely means 101 and

25/32 USD.

{R + [(FV - PP)/M]}

Investment yield = ------------------------------

[(FV + PP)/2]

R = coupon rate FV = face value

PP = purchase price M = years to maturity

Treasury Bonds

– Have the longest maturity, from fifteen to thirty years.

– Have a coupon payment every six months like T-Notes, and are currently only

issued with a maturity of thirty years.

– The U.S. Federal government suspended issuing the well-known 30-year Treasury

bonds (often called long-bonds) for a four and a half year period starting October

31, 2001 and concluding February 2006.

– As the U.S. government used its budget surpluses to pay down the Federal debt in

the late 1990s, the 10-year Treasury note began to replace the 30-year Treasury

bond as the general, most-followed metric of the U.S. bond market.

– However, because of demand from pension funds and large, long-term

institutional investors, along with a need to diversify the Treasury's liabilities the

30-year Treasury bond was re-introduced in February 2006 and is now issued

quarterly. This brought the U.S. in line with Japan and European governments

issuing longer-dated maturities amid growing global demand from pension funds.

Zero-coupon Securities. A zero-coupon security is one that does not pay interest until its final

maturity. By stripping the coupons from a bond, it is possible to offer investors Treasury

obligations that pay principal or interest on future dates with the original investment priced at a

substantial discount from the maturity value. Zero-coupon securities also permit investors to

“lock in” a specific return.

Federal Agency Securities. In addition to the U.S. Treasury, numerous federal agencies and

government-sponsored corporations (instrumentalities) issue debt. Some of these obligations are

guaranteed by the full faith and credit of the U.S. Government, but most of them carry only a

“moral obligation” to protect investors. The securities are not as widely traded as treasury

obligations, and their lack of guarantees leads to higher yields. Because of federal involvement,

most states authorize these investments for their local governments.

TIPS

Treasury Inflation-Protected Securities (or TIPS)

Inflation-indexed bonds issued by the U.S. Treasury.

The principal is adjusted to the Consumer Price Index (CPI), the commonly used measure

of inflation.

– When the CPI rises, the principal adjusts upward. If the index falls, the principal

adjusts downwards.

– The coupon rate is constant, but generates a different amount of interest when

multiplied by the inflation-adjusted principal, thus protecting the holder against

inflation.

TIPS are currently offered in 5-year, 10-year and 30-year maturities.

STRIPS

Separate Trading of Registered Interest and Principal Securities (or STRIPS)

T-Notes, T-Bonds and TIPS whose interest and principal portions of the security have

been separated, or "stripped“.

The name derives from the days before computerization, when paper bonds were

physically traded; traders would literally tear the interest coupons off of paper securities

for separate resale.

The government does not directly issue STRIPS; they are formed by investment banks or

brokerage firms, but the government does register STRIPS in its book-entry system.

They cannot be bought through TreasuryDirect, but only through a broker.

STRIPS are used by the Treasury and split into individual principal and interest

payments, which get resold in the form of zero-coupon bonds. Because they then pay no

interest, there is not any interest to re-invest, and so there is no reinvestment risk with

STRIPS.

Collateralized Mortgage Obligations

First introduced in 1983, the Tax Reform Act of 1986 allowed CMOs to be issued in the

form of real estate mortgage investment conduits (REMICs). Almost all CMOs are

REMICs.

CMOs are collateralized debt obligations (CDO) consisting of mortgage-backed

securities (MBS) that are separated and issued as different classes of mortgage pass-

through securities with different terms, interest rates, and risks.

CMOs are agency CMOs that are guaranteed by the Government National Mortgage

Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), or

the Federal Home Loan Mortgage Association (Freddie Mac).

CMOs by private issuers, collectively referred to as non-agency CMOs, achieve a AAA

rating through the use of credit enhancements.

CMO bonds differ from corporate and government or agency bonds in that payments are

made monthly or quarterly instead of semi-annually, the payments may consist of both

principal and interest, and, although specific CMO bonds may have stated maturities, the

actual lifetime of the bond will depend on prepayment rates, and it could be longer or

shorter than the stated maturity date.

– 10 yr. or less stated final maturity date

– Cannot be either an Interest-Only or Principal-Only CMO

The following are not permitted:

– inverse floater CMO

– Principal only CMO

– Interest only CMO

– Maturity greater than 10 years

Depository Instruments. Banks and savings and loan associations offer short-term instruments.

Two instruments are noteworthy: the interest-bearing deposit account (NOW or MMDA) and the

certificate of deposit (CD).

Repurchase Agreements. A repurchase agreement is where an investor exchanges cash to

receive government securities for a specified period of time. This can be done overnight, for a

specific term (maturity), or on a indefinite (open) basis. The interest rate paid for the use of the

cash is determined by negotiation or bidding. Upon maturity, the investor returns the securities

and receives cash plus accumulated interest.

Commercial Paper. These are unsecured promissory notes of corporations maturing in less than

270 days. They carry no government guarantees or insurance and entail considerably higher

credit risks. Issued at a discount and carries a zero coupon.

PFIA Requirements:

– 270 days or fewer

– Rated not less than A-1 or P-1 by at least:

• Two credit rating agencies; or,

• One credit rating agency and an irrevocable bank letter of credit

Bankers’ Acceptances. To finance foreign trade transactions, large banks issue acceptances of

trade bills. These instruments are usually high-quality money market securities, and usually trade

in denominations of $1 million or $10 million. Most BAs trade on a discount basis with

maturities under 60 days.

PFIA Requirements:

– 270 days or fewer

– Liquidated in full at maturity

– Eligible Federal Reserve Bank collateral

– U.S. Bank rated not less than A-1 or P-1

Certificates of Deposit. A certificate of deposit or share certificate is an authorized investment

under PFIA if the certificate is issued by a depository institution that has its main office or a

branch office in this state and is:

guaranteed or insured by the Federal Deposit Insurance Corporation or its successor or the

National Credit Union Share Insurance Fund or its successor;

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

secured in any other manner and amount provided by law for deposits of the investing entity.

(b) In addition to the authority to invest funds in certificates of deposit under Subsection (a),

an investment in certificates of deposit made in accordance with the following conditions is

an authorized investment under this subchapter:

the funds are invested by an investing entity through a depository institution that has its main

office or a branch office in this state and that is selected by the investing entity;

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;

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;

the depository institution selected by the investing entity under Subdivision (1) acts as

custodian for the investing entity with respect to the certificates of deposit issued for the

account of the investing entity; and

Brokered Certificates of Deposit. Brokered CDs are now allowed after the 2011 Legislative

session. The requirements are:

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

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;

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.

Investment Pools. Many states have created investment pools in which localities can invest that

operate like commercial money market funds. These pools offer the advantage of daily liquidity,

economies of scale through combined purchasing, and diversification and professional

management.

PFIA Requirements:

– Governing body must authorize investment in pool

– Can only invest in obligations approved by the Act

– Provide an offering circular containing information required by the Act

– Provide investment transaction confirmations

– Provide a monthly report containing information required by the Act

– Pool created to function as a money market mutual fund must mark its portfolio to

market daily and stabilize at a $1 net asset value.

– Must have an advisory board as specified by the Act

– Rated not less than AAA or an equivalent rating by at least one nationally

recognized rating service.

Money Market Mutual Funds. Several states permit local governments to invest in money

market mutual funds. Like their retail counterparts, investment companies offer institutional

money market funds to governmental investors. These S.E.C.-regulated instruments employ an

independent custodian, and operate under a trust agreement.

No-Load Money Market Funds

PFIA Requirements:

– Registered with and regulated by the Securities and Exchange Commission

– Provide a prospectus and other information required by the Securities Exchange

Act of 1934 or the Investment Company Act of 1940

– Must have a dollar-weighted average stated maturity of 90 days or less

– Must include in its objectives maintenance of a stable net asset value of $1

– Investing entity may not own more than 10% of the fund’s total assets

Mutual Funds

PFIA Requirements:

– Registered with the Securities and Exchange Commission

– Must have an average weighted maturity of less than two years

– Can only invest in obligations approved by the Act

– Rated not less than AAA or its equivalent by at least one nationally recognized

investment rating firm

– Comply with information and reporting requirements for investment pools as

described in the Act

– Amount limited to 15% of investing entity’s monthly average fund balance,

excluding bond proceeds, reserves, and debt service funds.

– Ineligible for investment of bond proceeds, reserves, and debt service funds

– Investing entity may not own more than 10% of the fund’s total assets

Investment Pools

PFIA Requirements

– Governing body must authorize investment in pool

– Can only invest in obligations approved by the Act

– Provide an offering circular containing information required by the Act

– Provide investment transaction confirmations

– Provide a monthly report containing information required by the Act

– Pool created to function as a money market mutual fund must mark its portfolio to

market daily and stabilize at a $1 net asset value.

– Must have an advisory board as specified by the Act

– Rated not less than AAA or an equivalent rating by at least one nationally

recognized rating service.

Below is a PFIA summary of the various requirements and limitations regarding pools and funds

Guaranteed Investment Contract or Flex-Repo

A fixed rate, fixed maturity contract similar to a bond.

Unlike a bond, a guaranteed investment contract is always valued at par (face) value.

– This occurs because the company issuing the guaranteed investment contract,

usually an insurance company, guarantees the investment by agreeing to pay the

difference between the market value and book value for the issue if the investor

decides to sell it.

A guaranteed investment contract may be structured in a manner similar to a flexible

repurchase agreement, whereby the investor is able to draw down the balance upon written

request throughout the life of the contract.

Authorized investment for bond proceeds

– Defined termination date

– Secured by Section 009(a)(1) of the PFIA

– Third party safekeeping

Term may not exceed 5 years from date of bond issuance, excluding reserves and debt

service funds

– To be eligible:

• Must specifically authorize when authorizing bonds

• Three bids

• Highest yield

• Drawdown schedule

• Reasonable administrative costs

No-Load Money Market Mutual

Fund

No-Load Mutual

Fund

Constant Dollar

Pool

Floating Net

Asset Value Pool

Restricted to Public Funds Inv. Act Authorized Investment

N

Y

Y

Y

Rating Required

N

Y

Y

Y

Weighted Average Maturity (WAM) Limit

90 days

2 years

90 days

None

Stable Net Asset Value (NAV) at $1

Y

N

Y

N

Requires Advisory Board

N

N

Y

Y

Investment Amount Limits (maximum)

None

15% of operating funds, excluding bond reserve and debt service funds

None

None

Investment Bond Proceeds

Y

N

Y

Y

Weighted Average Maturity (WAM) calculation using stated or reset dates

Reset

Stated

Stated

Stated

Public Funds Investment Act Disclosure Requirements

N

Y

Y

Y

Israeli Bonds. Debt securities issued by the Government of Israel.

In summary, the following are the only investments allowed by the Public Funds Investment Act:

– U.S. government obligations, including letters of credit.

– State of Texas direct obligations.

– Obligations of other states, agencies, counties, cities.

– Collateralized mortgage obligations.

– Bankers’ acceptances.

– Commercial paper.

– Repurchase agreements, including securities lending.

– Certificates of deposit.

– Share certificates.

– SEC-registered no-load money market mutual funds.

– SEC-registered no-load mutual funds.

– Local government investment pools.

– State of Israel bonds.

– Guaranteed investment contracts.

Investment Safekeeping

Prudent public investors minimize risks by arranging for their investment securities to be held by

an independent third party--somebody other than the depository bank, dealer or investment

company from whom the securities are purchased. The following general guidelines apply to

different investment instruments.

Government Securities. Ownership of U.S. Treasury securities and some federal agency

securities is recorded by computerized “book entry” on the records of a Federal Reserve Bank.

The government’s custodian bank usually will be listed on the Fed’s booked entry system, with

ownership shown as “customer account” or “trust account.” Local governments generally cannot

have their own name shown on the book-entry system. Therefore it is very important that

ownership be placed with an independent party--either a financial institution other than the one

acting as seller, or possibly in the trust department of a local bank (provided there is a written

trust agreement). A written safekeeping confirmation should be provided for each security held

by the custodian.

Repo Collateral. Securities purchased under a repurchase agreement should also be delivered to

an independent custodian or a bank trust department, subject to a written safekeeping/custodial

agreement. Governmental investors should avoid “hold in custody” repos, in which the dealer or

bank holds the collateral with no segregation and independent verification to protect the

customer.

Deposit Collateral. To protect public deposits, some states require each bank to segregate

government securities. Collateral usually can be transferred to a Federal Reserve Bank or to a

third-party bank, which protects the entity against financial failure.

Mutual Funds. Most mutual funds employ independent bank custodians for their portfolio

safekeeping. Before investing in a money market mutual fund or a short-term government bond

mutual fund, investors should verify (1) whether the portfolio is held by an independent

custodian, (2) whether the fund requires delivery vs. payment (DVP) in its portfolio transactions,

and (3) whether the fund purchases insurance against fraud, embezzlement and computer errors.

These protections are offered by many mutual funds and should not be overlooked.

Short-Term Borrowing

Short-term borrowing, is frequently an important component of an effective cash management

program. It is generally used to finance temporary cash flow deficits and enable governments to

meet budgeted expenditures, such as payrolls, prior to the receipt of current revenues. Short-term

borrowing is also used as temporary financing for long-term capital improvement projects. In

some instances, borrowing has been used as a means to earn additional interest income for a

government through arbitrage investing.

The ability of governments to borrow in the short-term is restricted by law and by other factors,

such as local policies regarding debt issuance. State and local laws and local debt policies

generally specify who can borrow, how much can be borrowed, from whom money can be

borrowed, and what types of debt can be issued. Federal laws and regulations, such as those

governing the earning of arbitrage interest, also act as constraints upon a government's ability to

finance temporary cash deficits.

The ability of governments to engage in short-term borrowing is also dependent upon access to

the credit markets. Access depends on a number of factors, including:

1) The creditworthiness of the issuer;

2) A demonstrated record of performance in the credit markets based upon the prior

issuance of debt;

3) A favorable market environment, with stable interest rates; and

4) The ability and experience of management in implementing a financing plan.

Governments engaging in short-term borrowing must understand that too much short-term debt

can lead to fiscal problems. Therefore, when governments find it necessary to issue short-term

debt, it should be for a specified time period and only when the revenues to repay the debt are

assured. Furthermore, short-term debt, borrowing for operating purposes should always be repaid

by the end of the fiscal year which the funds were borrowed.

Investment Transactions

Control of risk in an investment management program includes policies and procedures for the

conduct of investment transactions. Vendors of investment products should be selected according

to established criteria and then reviewed periodically based on performance and other

appropriate standards approved by the governing body or the designated investment committee.

In addition to being sellers of instruments, banks are also facilitators of investment transactions.

The depository bank should be selected through a competitive bid process, and one of the

evaluation factors in that process should be the bank’s securities clearing and safekeeping

capability. All securities transactions should be conducted on a delivery vs. payment (DVP) basis

as required by Public Funds Investment Act 2256.005(b)(4)(E), and the bank’s procedures for

handling failed transactions should be clearly understood and documented.

Banks also offer many investment products to governments, including U.S. Government

securities, mutual funds, repurchase agreements, and interest-bearing accounts such as

certificates of deposit and FDIC products. A bank’s creditworthiness should be reviewed even

though all deposits may be fully collateralized. The government’s interest in the collateral must

be perfected according to requirements of state and federal law. Perfected meaning a security

interest in the collateral that is used to secure the performance of a debt that is protected from

third-party claims.

Local government investment pools and mutual funds should be evaluated for compliance with

state law and the government’s investment policy. For example, if the investment policy only

permits investment in money market mutual funds and investment pools functioning as money

market funds, then funds and pools with fluctuating share prices should not be considered.

Offering statements for investment pools should be read carefully. The pool’s performance

history should be studied and compared with other investment alternatives.

Portfolio maturity restrictions should be evaluated to determine potential market and credit risks.

The qualifications and experience of the portfolio manager should be evaluated in terms of both

the individual and organization fulfilling this function. Portfolio pricing practices, including any

designed to maintain a stable unit/share price, should be evaluated. Custodial policies should be

reviewed. All investors in mutual funds should read the prospectus. The size, depth, and history

of the investment organization should be evaluated. Fees should be investigated; the total

expense ratio should be determined. Earnings performance histories should be evaluated.

Both investment pools and mutual funds should be checked for compliance with any rating and

information disclosure requirements imposed by either state or federal laws. Procedures for

deposit and withdrawal of funds should be verified.

Governments also purchase investments from broker/dealers. There are different types of

broker/dealers and investment advisors offering similar services. A broker can be defined as one

who brings buyers and sellers together for a commission. By definition, brokers do not take a

position in the assets being exchanged. Their function is to provide a communications network

that brings market participants -- buyers and sellers -- together to exchange assets. A dealer

makes markets in money market instruments by quoting bid and asked prices at which they are

prepared to buy and sell. Dealers will buy and sell to each other, to issuers, and to investors.

A firm may operate as a broker/dealer by bringing buyers and sellers together in its function as a

broker and by taking a position of its own in selected securities in its function as a dealer. A

subcategory of dealer is a primary dealer. A primary dealer is one who makes a market in

government securities and has met certain minimum financial criteria set by the Market Reports

Division of the Federal Reserve Bank of New York. The second tier of dealers generally includes

firms that meet certain market needs and attempt to position themselves in specific sectors of the

market. Often secondary dealers will seek to meet the needs of their clients by offering

instruments that match the cash flow needs of the government. Secondary dealers may operate

regionally or nationally.

Many public fund investors lack the resources necessary to search the money market properly or

on a timely basis and, therefore, look to brokers/dealers to find market opportunities for them.

Providing access to the money markets is a major function of the broker/dealer community.

Other important functions of the broker/dealers are market analysis, portfolio analysis, credit

research, securities analysis, and relative value analysis. These services represent the advantages

of using broker/dealers. The disadvantages of using broker/dealers arise mainly from lack of

monitoring the cost of investment transactions and lack of adherence to the government’s

approved investment policy. These disadvantages can be controlled by developing a selection

process for broker/dealers -- and other investment vendors -- and by monitoring the performance

of all firms involved in the government’s investment program.

Investment advisers offer investment advice to governments for a fee. Advisers differ in the size

of the firm, the range of services offered, and the amount of fee charged. Investment advisory

firms may be bank trust departments, national investment management firms, specialized

boutique firms, or small independent consultants. Some investment advisory firms offer

prepackaged investments, such as mutual funds or investment pools, while other firms offer

customized portfolio services that may include consulting activities for the cash management

function, such as cash flow forecasting. Investment advisors may also act as broker/dealers. If

this is the case, the investment advice offered may not be the sole objective since trading

securities generates income for the firm. Investment advisers may be given either discretionary

or non-discretionary authority in managing the government’s portfolio.

As with broker/dealers, there are advantages and disadvantages to using investment advisers. The

advantages include greater access to the capital markets than the government’s limited resources

would permit leading to wider diversification of the investments as allowed by the investment

policy. Some investment advisers have expertise in specific sectors of the market and can

enhance returns by developing investment strategies to make the most of market opportunities in

those sectors. Advisers may also be used to complement internal resources and to strengthen

internal controls. The disadvantages of investment advisers include the overall cost an adviser

may add to the investment management process. In some cases, investment advisers will be

unable to produce sufficiently high returns to offset the cost of the service. Public funds investors

must also remember the responsibility for the portfolio remains with them and cannot be

delegated to an adviser. The adviser should be selected through a request for proposal and

performance monitored according to standards established in an investment advisory agreement.