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Steps To Prudent Investing
of Program Funds

By
Stan Provus
Stanley Provus & Associates, Inc.
501/760-6000: provus@hsnp.com

"Investors should care less about the return on their principal than they do about the return of their principal." Will Rogers

This paper summarizes a checklist of steps to successful investment management of program funds, highlights certain steps in some detail, provides explanations of several investment instruments Alternative Finance Program (AFP) administrators may choose to use, and provides examples of program cash flows. As used in this paper, the term "program funds" means NIDRR grant and matching funds.

Summary of Steps

1. Identify the organization’s objectives, constraints, preferences and capabilities

2. Develop investment policies

3. Develop administrative systems and internal controls

4. Prepare a cash flow forecast

5. Determine the investment horizon

6. Establish an investment outlook and strategy

7. Analyze the yield curve

8. Select optimizing instruments (choose your weapons)

9. Monitor the markets and investment results

10. Report results

11. Adjust and rebalance the portfolio accordingly

Step 1: Identify your objectives, constraints, preferences and capabilities

First, an Alternative Finance Program (AFP) should consider engaging a professional investment advisor, typically from banks, particularly trust departments, investment banks or outside consultants. For state agencies this may be a staff person in the state treasurer’s office. The AFP administrator must be able to articulate their primary investment characteristics to investment advisors. Investment advisors must know and understand your investment objectives and characteristics leading to formal investment policies.

For AFPs , key program characteristics that must be considered include:

Safety first. Your primary investment objective is to earn market rates of return while preserving and protecting capital—your capital is NIDRR grant funds and the match. This means avoiding any speculative investments or volatile investment instruments.

Legal Constraints. The AFP enabling legislation places certain constraints on investments. Specifically, "Regulations provide that a State’s community-based organization (CBO) will invest funds in low risk securities in which a regulated insurance company may invest funds under the law of the state if the organization administering funds invests funds within this account." All monies that support the AFP (Federal, match) are treated similarly. They become one account and are treated as a common account.

The statute also requires that the CBO invest funds not the state. However, it appears the CBO could take formal action to elect to invest funds with the state, if the state, in turn, could accept such investment responsibility. Sections 304(a) and 303(5) (B) (C) of the statute provide guidance on legal requirements.

You can determine legal investments of insurance companies by calling your state insurance department or commissioner. They will direct you to the appropriate state legislation that limits investments. Generally, these laws are conservative. Many regulations limit investment instruments to a percentage of total assets. For example, in Arkansas an insurance company cannot invest more than 25% of their assets in common stock. Some state laws may not cover all investment types such as Guaranteed Investment Contracts (GICs) reviewed below. In this instance, check to see if the standards established by the National Association of Insurance Commissioners permit a particular type of investment. GICs, for example, are admitted investments by NAIC.

Program Design/constraints and Time horizons. In addition to direct revolving loan fund programs there appears to be two types of AFP loan guaranty programs in operation. The first type of loan guaranty program is a full or partial "linked Deposit" program. With linked deposits, a lender’s loan is secured by a linked certificate of deposit (CD) or money market investment made by the AFP administrator with a financial institution originating a guaranteed assistive technology loan. The linked deposit is generally for the same term as the assistive technology (AT) loan and may provide the lender a source of funds for making the loan in addition to a guaranty—if the loan defaults, the CD or money market investment can be drawn on to pay any losses.

With some guaranty programs, administrators may be purchasing these instruments in an amount equal to only a percentage of an AT loan such as 50% but the lender may still receive a 100% guaranty—other program funds provide claims paying coverage, if necessary. Linked deposits provide little flexibility with respect to investment instruments and returns. However, such investments are covered by FDIC insurance up to $100,000 per institution. If $100,000 is exceeded the investment instruments can be collateralized.

The second type of loan guaranty program is one that provides a guaranty to a lender pursuant to a loan guaranty agreement but there is no relationship between the guaranty and how program funds are invested. We’ll call this the "traditional" guaranty program that operates similar to the Small Business Administration loan guaranty programs. Finally, there are direct revolving loan funds under which loans are made directly to AT borrowers, although such programs may employ a financial administrator to book and service loans on a fee for service basis.

Each of these three models will influence investment objectives in different ways, particularly with respect to investment time horizons. Linked deposit programs provide the least amount of flexibility, since purchased investments are typically made for the term of each AT loan. Locking in five-year rates, for example ( assuming a 5 year AT loan) in today’s exceptionally low interest rate environment is a questionable practice but could make sense once rates return to more historical return levels.

With traditional guaranty programs there must be some concern for liquidity to get cash fast to honor guaranty commitments. However, it is very unlikely given current and Maine’s 10 year experience with AT loan or guaranty programs that losses will exceed more than a small percentage of outstanding guaranteed loans. Maine’s loss ( net charge-offs) experience is less than 1%. A very conservative net charge-off assumption would be 10-25%. This means program administrators could invest a significant amount of funds at least at intermediate term levels up to 4-7 years. Historically, the yield curve is positively sloping meaning longer term investments pay higher interest rates.

Cash flow forecasts are particularly important in direct loan programs. Loan origination forecasts determine when funds will be needed to book loans. At current national loan origination rates, it would likely take 4-5 years to originate $ 2 million of loans. This permits staggering some investments to earn higher returns. Cash flow forecasts should be updated annually as actual experience can be used to refine forecasts. Cash flow forecasts are used to estimate the amount and term of investable funds on a monthly or annual basis.

Preference of Board and staff. It’s a good idea to have one person on a community-based organization board with financial experience, including investments.

Source of funds. The federal legislation clearly limits investments to "low-risk" investments, meaning the investment portfolio should not sustain any principal losses on invested capital.

Earn market rates of return. It is intended that AFPs operate in perpetuity. Generally, the ability to do this will be a function of several program income and expense items. Many programs will not be able to grow or sustain initial loan origination funding levels if program expenses ( net charge-offs or losses plus administrative costs plus interest buy downs, if any, exceed program income—income from invested funds is the only source of income for guaranty programs while principal and interest payments represent the major income source of income for revolving loan funds.

Given a very low risk tolerance, the need to earn market rates of return is the second most important investment consideration. Sleepy cash management practices may leave funds uninvested, which costs programs money. Always maximize the volume of investable funds.

Step 2: Develop Investment Policies

Many investment professionals like bank trust departments now insist on written investment policies as a way to guide and protect their portfolio managers. Formal policies help clients understand the nature of the investment process and risk-return relationship.

Investment policies should include the following elements:

  • Explicit statements of the organization’s investment objectives, preferences, statutory constraints and management capacity, summarizing findings from Step 1.
  • Delegation of investment authority. The policy should identify those persons responsible for making investment decisions.
  • Identify Investment Horizons. Given the AFP programs, the policy should identify short-term and intermediate term investment horizons—the term of investments to match catch flow needs.
  • Identification of appropriate investment instruments. This list should identify the universe of potential investment instruments from money market funds to T-Bills to CDs to other instruments.
  • Maturities/volatility. AFP administrators should avoid instruments with long maturities and high volatility of prices. Even a " riskless" U.S. Government Bond can lose 10 –15% of its value if interest rates increase by 3%. This loss, however, is only experienced if the bond must be sold in an environment of increasing interest rates—to pay, for example, loan guaranty claims. The volatility of an investment instrument is a lesser concern if the investment time horizon is long term like pension funds. Market volatility can be minimized with a buy and hold investment strategy.
  • Diversification. The investment policy should include guidance on diversification in terms of the percentage of funds invested in a single class of securities and maturities. The program should consider whether it makes sense to invest all funds short-term or longer to protect against and take advantage of interest rate changes.
  • Default risk should be a prime concern of the investment policy. Many states, for example, require collateralization of public deposits, and some require that all securities be government guaranteed, collateralized with safe securities, or insured.
  • Credit evaluation in terms of the provider of an investment instrument if the instrument is not insured or secured or actual rating of the investment instrument like A-1+ commercial paper.
  • Other investment policies should consider internal controls, documentation of investment decisions, and reporting investment results.

Step 4. Prepare a Cash Flow or flow of funds Forecast. See attached exhibits. Cash flow forecasts show cash flow projections and estimates of investable cash balances. The annual examples shown as exhibits could be done on a monthly basis to more precisely estimate investable funds. They could also be modified to show existing investments and their maturities. The cash flow forecast anticipates cash receipts and expenses and determines the maximum possible investment instrument maturity that can be used.

INVESTMENT INSTRUMENTS

How prior grantees (FY2000) currently invest program funds.

FY2000 grantees include Kansas, Maryland, Missouri, Pennsylvania, Utah and Virginia. We conducted a survey with each state and found that they are investing program funds into state cash pools, bank money market funds and CDs, and Treasuries. At least two states invest in their lender money market accounts as part of their loan guaranty agreements to secure their guaranty on individual loans—a form of "linked deposit" program. These states invest an amount equal to 50% of the loan amount, although they still provide a 100% guaranty.

AFP investors may want to consider the following types of investment instruments:

State Investment Pools

In many states the state treasurer or an authorized governing board oversee a pooled investment fund that operates like a money market fund but only for the benefit of state and/or local governmental entities. These pools typically combine the cash of participating jurisdictions and invest the assets in securities otherwise allowed under the state’s laws regarding government investments. Interest is apportioned to participants on a daily basis. Due to the large amount of cash invested and somewhat longer maturities, state pools typically offer more attractive interest rates than either bank or private money market mutual funds.

A number of operating AFPs invest with state pools. State administrators of investment pools must decide whether or not any particular AFP is eligible for inclusion in the state investment pools. Prior to approaching the state treasurer for participation in state investment pools, the community-based organization should take formal action to place its investment program with a state agency or entity that, in turn, qualifies for participation. Generally, private non-profit organizations cannot participate in their own right.

Certificates of Deposit

A CD is a time deposit with a financial institution that pays interest on a fixed or variable basis. The Bond Market Association web site, www.bondmarkets.com, provides a good guide to investing in CDs for investors. Early redemption typically triggers rate penalties. CDs are a widely used investment tool for local governments that offer considerable flexibility in terms of denominations, rates, and maturities. They also carry FDIC insurance up to $100,000. The FDIC insurance makes the quality of the financial institution a secondary concern. If you purchase more than $100,000 from a single financial institution, banks can collateralize the CD with government or other high-grade securities but the interest rate will be lower on collateralized CDs. CDs are issued by banks and other financial institutions. There are many sites on the Internet that provide information about CD rates and maturities from financial institutions across the country.

US Treasury Securities

Treasury securities are a safe and secure investment option because the full faith and credit of the United States government guarantees that interest and principal payments will be paid on time. Also, most Treasury securities are liquid, which means they can easily be sold for cash.

Treasury bills (or T-bills) are short-term securities that mature in one year or less from their issue date. You buy T-bills for a price less than their par (face) value, and when they mature they pay you their par value. Your interest is the difference between the purchase price of the security and what they pay you at maturity (or what you get if you sell the bill before it matures). For example, if you bought a $10,000 26-week Treasury bill for $9,750 and held it until maturity, your interest would be $250.

Treasury notes and bonds are securities that pay a fixed rate of interest every six months until your security matures, which is when Treasury pays you their par value. The only difference between them is their length until maturity. Treasury notes mature in more than a year, but not more than 10 years from their issue date. Bonds, on the other hand, mature in more than 10 years from their issue date. You usually can buy notes and bonds for a price close to their par value.

Treasury sells two kinds of notes and bonds, fixed-principal and inflation-indexed. Both pay interest twice a year, but the principal value of inflation-indexed securities is adjusted to reflect inflation as measured by the Consumer Price Index -- the Bureau of Labor Statistics' Consumer Price Index for All Urban Consumers (CPI-U). With inflation-indexed notes and bonds, Treasury calculates your semiannual interest payments and maturity payment based on the inflation-adjusted principal value of your security.

Repurchase Agreements

Repurchase agreements (repos) are the sale by a bank or dealer of a government security with a simultaneous agreement to repurchase the security at a later date. A repo is nothing more than collateralized lending as the terms of the transaction are structured to compensate for the funds lent and the cost of the transaction is the repo rate. The repo rate is the annualized interest rate for the funds lent by the lender to the borrower (repo seller). Repos are commonly used by public entities to secure money market rates of interest.

The Government Finance Officers Association recommends that governmental entities exercise caution in selecting parties with whom they will conduct repo transactions; repos be properly or fully collateralized with low-risk securities such as T-bills; and that the collateral be marked-to-market and held by a custodian (trustee) for the lender or purchaser.

Money Market Mutual Funds

The Securities and Exchange Commission regulates Money Market Mutual Funds. The funds operate under strict guidelines regarding their maximum maturities, diversification requirements and the conditions for taking delivery of their investments. Many money market funds, however, invest a portion of their funds in securities not allowed by many governmental and possibly insurance company investment guidelines. Bank money market funds are eligible for FDIC insurance but returns can be very modest.

AFP investors may want to consider bank money market funds with FDIC insurance as well as those money market mutual funds whose portfolios consist of government securities or other prime money market instruments.

Guaranteed Investment Contracts

Guaranteed investment contracts ( GICs) are used widely in the municipal bond industry. They are offered by highly rated ( AAA-AA) insurance companies and bond insurers, among others. GICs offer to pay a fixed interest rate over a specific time period. The insurance companies that provide them guarantee them and they can also be collateralized. Collateralized GICs would pay lower interest rates. Some GICs permit considerable flexibility with and without rate penalties for early redemption. In the context of the AFP, a GIC could be acquired to invest loan loss reserves for guaranty programs and to temporarily invest program funds prior to draw down to make loans in direct revolving loan fund programs. The AFP would be required to give the provider a schedule of estimated draw downs—in many cases, these estimates can be accelerated (faster draw down schedule) or slowed without rate penalties to access program funds for operations when needed—paying claims on insured loans, originating direct loans, etc.

Most providers will not consider GICs for less than $1.5 million-$2million, depending on the maturity. Providers offer more flexibility for longer term GICs.

Exhibit A - Loan Guaranty Program Projections
Exhibit B - Direct Revolving Loan Fund Program Projections
Exhibit C - Worksheets for Loan Guaranty Projections (Excel format)
Exhibit D - Worksheets for Direct Revolving Loan Fund Projections (Excel format)