Public Funds Investment Institute

Countdown to Shutdown

September 29, 2023
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With the clock ticking it seems like the only thing that is certain is uncertainty. 

Do not expect financial market volatility because the shutdown will not affect the repayment of US government debt.  But it will certainly add uncertainty to cash flow planning for state and local governments that receive Federal payments and will lead to suspension of economic releases that drive the financial markets. This will leave portfolio managers disadvantaged when it comes to gauging the current economic activity.  There are, of course, some private sector measures of macro-economic effects.  For example, the ADP Employment Report that is released two days before the report from the Burau of Labor Statistics. But investors tend to discount severely these private sector estimates. So, the markets will be flying blind for a time.

Save well (keep sample liquidity) and invest cautiously until (hopefully) things settle!

Moody's Climbs on Board

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Moody’s became the most recent ratings agency to warn that the fiscal chaos in Washington could lead to a downgrade of the credit rating of the United States.   The rating agency’s position was reported early this week by Reuters  and described in a FAQ released by the credit ratings agency.

This could be viewed as a half step or warning by the ratings agency, as it did not formally put the credit rating on watch for downgrade.  Interestingly, it follows an annual review of the credit rating released by Moody’s last month that affirmed the Aaa rating.  FitchRatings downgraded the credit of the US to AA+ in August.   S&P Global has had the credit rating at AA+ since 2011.  

The reality is that for the most part investors do not use credit ratings to evaluate the sovereign credit of the United States, and the markets were unmoved by the Moody’s announcement.

That said, as we observed when Fitch took its actions, a downgrade could raise issues for public sector investors where state statutes, bond indentures and/or investment policies specify credit ratings for debt of the United States and its agencies and instrumentalities.

One might say that credit rating requirements on sovereign debt of the United States are an artifact of a simpler (saner?) time. Best practice would be not to reference ratings in investment guidance when it comes to direct obligations of the United States.  Its credit is whatever its credit is.

That is not the case when it comes to the credit of Federal agencies and instrumentalities. Their ratings generally follow those of the sovereign debt, but not all Federal agencies have the same level of real or implied support from Uncle Sam.  Ratings are not a sufficient way to assess the creditworthiness of these entities.  But it would be a mistake to assume that all debt issued by any and all Federal agencies is highly secure.  Therein lies the complication when it comes to credit.  Forward-looking investment policies could appropriately eliminate references to a rating for direct obligations of the United States and establish creditworthiness standards for other issuers.

FHL Banks 2nd Q. Advances Declined—Good News for Financial Stability but Less Opportunity for Investors.

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If you are a public funds investor—focused on safety and liquidity with a bias or requirement to invest short-term—the surge in issuance by the Federal Home Loan Banks is a good thing.  More supply = higher rates compared to alternatives. 

This was the case during the pandemic and accelerated in the first quarter of the year as banks rushed to borrow from FHLBanks to shore up their balance sheets or make up for deposit outflows in the aftermath of the Silicon Valley Bank failure.

 New data show that the borrowing trend partly reversed in the second quarter. FHL Bank loans to its members—technically “advances”—declined from $1.04 trillion to $855 billion.

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That meant that FHL Banks have fewer bonds and discount notes outsdtding.  The volume of advances is still much above that in prior years but compared to alternatives—particularly to short-term Treasury bills—FHL Bank notes are a lot less attractive now than they were a few months ago.

Investors oriented toward government obligations generally find alternatives to Treasuries in shorter supply and less attractive these days than they were in the pre-2008 hay day of Fannie Mae and Freddie Mac.  Short-term, high-quality portfolios that expanded their FHL Bank holdings in the quarter are enjoying a yield premium (interest rate spread) when compared with Treasuries that will be less available in coming months if the volume of outstanding FHL Bank debt continues to decline.

The Other Side of the FHL Banks Story

A couple of weeks ago we reported on the Federal Housing Finance Agency’s nearly completed review of the Fedal Home Loan Banks. Many commentators have noted that the FHL Banks seem to have strayed from their original mission of providing financing for affordable housing and have become an essential tool to support the banking system in times of stress.  The sharp rise in FHL Banks Advances in the first quarter evidence this.

Some Biden administration advisors, and some advocates for non-bank financial institutions (the Blackstones of the world), and mortgage lenders (Rocket Mortgage is an example), have suggested that the way to expand financing for housing is to open the FHL Banks borrowing facility to a broad class of non-banks.  The reasoning is that these institutions could gain access to cheap financing in return for commitments to originate affordable housing mortgage loans.

You might summarize this as the “go bigger” approach.

An expanded mission for the FHL Banks could lead to more issuance of debt and this would be welcomed by public funds investors.

But  an analysis by Bloomberg concluded that large financial  institutions are much less active in financing home purchases than small banks and Community Development Financial Institutions.

So maybe going big is not the answer--rather the system could refocus and reduce its presence.  Mega banks, who have dominated the FHL Banks Advances, could be throttled back, and funds could be better targeted to housing finance.  The result might be a leaner FHL Bank system with less debt issuance. 

As we noted in our comment in a prior issue of Beyond the News, the Federal Housing Financce Agency recommendation should be out shortly.  It could portend further changes in the Federal agency debt markets.  Which way—bigger or smaller—is TBD.  And keep in mind that changes like this will require Congressional approval.  Approval by the same body that has been considering re-structuring two other housing-related Federal agencies—Fanne Mae and Freddie Mac—since 2009.

Greetings, fellow colleagues in the public funds investment community! I'm Marty Margolis, a seasoned expert with a deep understanding of the intricacies of managing public sector investments. Having led the growth of PFM Asset Management and managing assets exceeding $150 billion, I am excited to connect with you through the Public Funds Investment Institute. If you haven't already — subscribe below to join our community, explore our thought leadership, and gain valuable insights. I encourage you to connect with me on LinkedIn or reach out via email to share your thoughts, feedback, and ideas. Let's collaborate and make a positive impact together.

Best regards,
Marty Margolis

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