Public Funds Investment Institute

Public Funds Investment Portfolios:  Steady with Little Growth Expected

December 8, 2023

Public funds investment assets have barely expanded this year, despite robust interest earnings that flow to investment portfolios. This is according to newly released Federal Reserve data. The Fed reports that investment assets totaled $3.7 trillion at the end of the third quarter, up $100 billion from December 31, 2022. The growth rate of 2.9% for the nine-month period is less than the pace of economic growth (GDP was up 4.5%) and about even with the rate of inflation. This followed growth of investment assets of 40% between 2018 and the end of 2021.

As the below chart illustrates, the period of strong expansion of public funds investment portfolio assets from 2019-2021 has been replaced with a slow growth/no growth trend.

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Robust investment income, which contributed 3.5%-4% to short term investment portfolios in the nine-month period, was offset by ebbing tax collections and an end to Federal programs that supported Covid-19 recovery.

By contrast, assets of money funds tracked by Crane Data ended the third quarter at $6.1 trillion, up $1 trillion or about 20% over the nine-month period.  Institutional investors (corporations and nonprofit organizations) accounted for about $400 billion of the increase and retail investors accounted for the balance.

Portfolio composition shows a strong preference for government securities. State and local investment portfolios continue to make heavy use of Treasury and Federal agency securities. Government obligations, held directly or through repurchase agreements, accounted for about 60% of investment assets at the end of the third quarter, according to the Fed data.

The trend to favor government obligations has been consistent over the past five years, but the mix has changed. This corresponds with the shrinking issuance of short-term Federal agency obligations and sharp increase in issuance of short-term Treasuries. Treasuries owned directly ($1.6 trillion) accounted for 44% of portfolio assets as of September 30, up from 30% ($772 billion) at the end of 2018. Combined holdings of Treasuries, Federal agencies and repurchase agreements totaled 61%, up from 57% in 2018. On the whole, portfolios held more higher credit and liquid assets as of September 30 than they did five years ago.

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Meanwhile holdings of corporate credit obligations declined by about $50 billion in the five-year period. At the end of the third quarter, they comprised about 7% of portfolio assets.

Bank deposits totaled $716 billion of investment assets as of September 30. The total was up by $180 billion or 34% over five years but bank deposits shrank to 19% of investment assets on September 30, down from 21% at the end of 2018. There has been a notable shift in assets out of time and savings deposits (down $58 billion) while checkable and demand deposits increased by $212 billion. Public funds bank deposits were down $14 billion (two percent) this year, a modest move considering worries about bank safety earlier in the year, and a lag in banks raising short term deposit rates as interest rates rose. Bank deposits from all customers have declined by about $400 billion (3%) since January 1.

Bottom line:  An end to Covid related  Federal aid, a modest pace of economic growth, and slowing state and local government revenue growth have slowed the growth of public funds portfolios. These factors seem likely to limit growth in coming quarters as well.

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A note on the data:  The Federal Reserve produces a quarterly report accounting for the financial assets of the United States (the Z,1 Release.)  It is a comprehensive effort to account for levels (net worth) and transactions for all sectors including households, businesses, and government. The details for state and local governments are the only comprehensive current estimates available. Some elements, like the level of bank deposits, are very accurate because they come from regulatory filings. Others, like holdings of corporate debt, use allocation factors that are not kept up to date or may not capture the reality. Also, it is unclear how the analysis accounts for holdings of local government investment pools whose assets total at least $700 billion. The estimates of asset levels are thus limited, but the estimates of trends from quarter to quarter do provide useful information to a point. There are general limits as to the availability of consistent and comprehensive data on public funds investments and the Fed’s Z.1 report should be considered with this caveat in mind.

The Big Bank Lineup

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Talk about a power line-up! The eight bank CEO’s who appeared before this week’s Senate Banking Housing and Urban Affairs Committee hearing represent financial institutions with about $15 trillion in assets. That’s nearly 65% of overall US bank assets.  It’s also about 60% of the US gross domestic product.  These bank CEOs were in Washington to advocate for withdrawal or reworking of proposed regulations to revise the capital requirements for major banks.

Why it matters. We’ve been over this a couple of times because the stakes are high, and there will be winners and losers as these rules—if adopted—will influence the re-making of the US financial system that has been under way for more than a decade.  

The hearing itself was rather bland by current Washington standards (no shoving, shouting, X trolling).   No one really likes banks—except of course their employees, homeowners who need a source of mortgage financing, or business owners who need loans to build/manage their businesses. The banks’ well-funded lobbying campaign, which includes billboards along Washington highways and streets and anti-Basel III Endgame advertisements during Sunday night football (?!) invoked all these constituencies.

While the CEOs warned of noxious effects on small business, residential mortgage borrowers and farmers, the Congressional Research Service (the non-partisan research arm of Congress) released a report last week that concluded “The proposal would have a larger capital effect on trading activities than on lending, and it is estimated to have the largest effect on globally systemically important banks.”

Public funds investors have a direct interest in these capital market activities which affect access to investments and the cost of buying, holding, and trading securities.

Put simply, the context of 300+ pages of proposed rules is that banks would have to allocate more capital to financial markets activities, driving up trading and financing costs. But the rules would not apply to non-bank organizations (hedge funds, mortgage finance companies, proprietary trading outfits). These organizations could gain some advantage over banks and, by expanding into the capital market they could drive down trading costs. So the ultimate impact on capital market economics is unknown.

That said, capital buffers provide insurance against failure but capital costs money—investors expect a hefty return on their capital. Once a buffer is exhausted there is no insurance—except of course if the failure is BIG the Federal Reserve and Treasury are likely to step in to maintain/restore financial stability. Bailouts cost money also but   their cost is in the future--and speculative--so it is not generally a part of the current discussion.

Meanwhile, if you are a public agency investor, mandated by law to consider safety first, there is good reason to look to deposit insurance to protect your investments. Federal deposit insurance is limited to $250,000 per depositor, but there are well established “insurance multiplication” networks (CDARS is the best-known) ,  that can extend this to deposits of $25 or even $50 million through multiple deposits. 

There are a lot of licensed banks—about 4,500 presently. The regulators point out that the new rules would exempt most of these as they cover less than 37 of the largest. These 37 banks account for perhaps 75% of bank lending and virtually all bank securities trading and capital market  actives.  Insurance multiplication works for large investors only because there are thousands of banks.

Concentrated ownership heightens the potential for failure to impact systemic risk and massive industry consolidation, if it occurs because of the application of the proposed regulations or an acceleration of industry economic trends, could reduce the opportunity to multiply insurance.

Bottom line:  This is about much more than whether the eight mega-banks will have to commit more capital to the business. The regulators have extended the comment period (originally November 30) to January 16, after which they will likely make changes, and issue final rules to be implemented over the next several years. The regulations may accelerate, or retard what are tectonic shifts in the business of banking.

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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