With the election over, here is a quick flyover of three policy moves that could alter the playing field for state and local government investors:
Crypto. Years of hype. rocketing (and volatile) returns on some crypto assets and pressure from the tech industry have brought crypto to the main stage, even if their utility in the broad financial markets is unclear.
The rise of crypto is unlikely to change the investment choices for state and local governments—at least in the short run. But blockchain technology and cryptocurrency as an alternative to fiat currencies (currencies backed by the resources of a national government) could impact money movement, securities settlement and safekeeping.
Be prepared to explain why these shiny crypto assets are not appropriate for low-risk public funds investment strategies, but understand that blockchain technologies have the potential to alter the way you pay for things, move money, and hold assets.
Consider the question of whether crypto is an investment asset or not. There is a good bit of confusion around this. “Crypto” is shorthand for cryptocurrency but the Internal Revenue Service classifies crypto as an asset for tax purposes and many of those who buy/hold crypto do so for an expected return on the asset rather than for the stored value. (Those who use crypto for criminal activity may look at it differently.)
There should be no doubt that the uncertain nature of crypto and the volatility of returns put it outside of the low-risk prudent investment universe. It may be fine for hedge funds and individual investors who have appetites for risk-taking. But that is not the profile of most public agencies, who should avoid adding crypto currencies to their investment portfolios, just as they would avoid investing in fiat currencies (e.g. the Japanese Yen) for an expected return.
The ascendance of crypto may also strengthen the move to use alternative digital currencies in market transactions. Its promoters will push for the use of blockchain technology to facilitate decentralized money movement and securities settlements. This would challenge such existing investment “truths” as paying “dollars” for goods, services or other assets (think bonds), keeping your money in a bank and transferring money and financial assets through centralized and regulated means (banks, brokers, central clearing organizations).
Promoters of crypto, including tech industry venturers who see an opportunity to “move fast and break things” (to quote Marc Zuckerberg) to create new business opportunities expect the Trump administration, its re-constituted regulatory agencies and Congress to bring crypto into the mainstream of the financial markets. Banks, who have a near monopoly on the system’s plumbing, may resist. There will be a monumental debate between the prudential regulators who see their mission as controlling systemic risk and those who want to throw off many of the elements of regulation in the hope/expectation that it will unleash a strong economic expansion.
Some have characterized crypto/blockchain with the phrase “there is no there there.” But there will be, sooner than you think. And though public agencies may look elsewhere for prudent investment returns, they will have to consider whether blockchain technology is appropriate for paying for things and recording ownership of assets.
Financial market regulation. The leadership of the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation will change, and the Federal Reserve will be under pressure to support the minimalist-regulatory philosophy of the new administration. The effects on financial markets regulations could be far-reaching.
A prominent result is likely to be sidelining of proposed rules on bank capital. When these rules were introduced in mid-2023 proponents argued they were needed to reduce the systemic risk that banking presented to the global financial system and level the playing field (especially regarding global systemic risks) for US-regulated banks and banks in other countries.
As proposed, the rules would also affect the competitive position of mega-banks vs. community banks and raise the cost of banking services like trading/market making and securities custody. Investors in bank equities would care about the competitive effects while bank customers, including state and local governments, should be concerned about the effect on costs and services.
The first Trump administration repeatedly invoked a strategy of “tailoring” regulations to limit their effect. This time around the move may be more aggressive. The expansive activities of the SEC and the bank regulators are likely to be curtailed. Maybe we’ll see Elon Must tearing up pages of rules in front of a camera or perhaps throwing them onto a bonfire. Some (perhaps a goodly number) will be related to the financial markets. The investment industry, which is chafing under the burden of regulation, is likely to be relieved; public agencies, which are largely exempt from such Federal oversight (though fraud is and will still be punished) may not be much impacted by first order effects of deregulation. But we should note that Gary Gensler, chair of the SEC, has argued that the plethora of new rules in the past four years was purposed to reduce financial system risk, advance market transparency and protect investors, and that pulling back would adversely affect investors and market risk/stability.
Government overreach or prudential regulation? Time may (or may not) tell, but one thing is certain: the rules of engagement will change with fewer new rules and a lighter regulatory hand on the markets.
The Federal financing agencies. Federal agency debt has been a core part of public funds investment portfolios for decades because many of the agencies have been considered to have the minimal risk and high liquidity of direct government obligations. Notably Freddie Mac and Fannie Mae nearly collapsed in the Great Recession. The government effectively took them over, securing their obligations.
Though the volume of outstanding Fannie Mae and Freddie Mac debt has diminished from more than $1 trillion in 2013 to $291 billion currently, agencies remain a favored investment for public agencies, representing 11% of their investment assets overall, because the agencies are considered to be too big or too essential (as a main component of Federal housing finance assistance programs) to be allowed to fail.
In the new administration these agencies would appear to be prime candidates for “reform.” Indeed Project 2025, which some view as a guide to Trump administration policies. calls for Fannie Mae and Freddie Mac to be “wound down.” While calling for other housing finance agencies, the Federal Housing Administration and Government National Mortgage Association to be “right sized.
Changes to the organization or business of these agencies could end their government sponsorship, alter their credit, and/or reduce their issuance volume. While the primary focus of such changes would be the impact on the housing sector, state and local governments should be alert to changes that would affect a core portfolio holding, alter the credit and/or reduce the volume of issuance.
One federal agency, the FHL Banks, originated to support housing finance but has morphed into a vehicle to give banks access to the debt markets at a rate nearly as low as the Treasury borrowing rate. The banks are staunch supporters of the FHL Banks, and it is likely to be largely untouched by agency reform moves.
The volume of outstanding Federal Agency debt (about $2 trillion) has been unchanged for a decade, but the composition has changed. The FHL Banks are behind about 45% of the debt, while Fannie Mae and Freddie Mac collectively represent about 10%.
Winding down or privatizing Fannie Mae and Freddie Mac could lead public agencies to increase holdings of FHL Banks debt (perhaps diversification among government-sponsored enterprises is not important?), or a shift to Treasury debt (which is in ample supply and likely to increase) or a move to some form of corporate or bank debt which has credit risk aspects.
Such changes are likely to be phased in over time and public agencies should have ample opportunity to assess implications, but changes to the Federal agencies are not without direct implications for public agency portfolios.
