As chair of the Michigan Liquid Asset Fund Plus (MILAF +) Board, I feel it's appropriate that I am writing a column on the topic of investing. As our resources in schools dwindle with the overwhelming upheaval in the financial markets in recent months as well as what is happening with the Big 3 auto companies, it is even more important to raise questions about the safety of investing and the use of collateral to secure investments or using the services of professionals where investing is their business.
Collateral is defined as an asset which is pledged by a borrower to secure a loan or other credit, and is subject to seizure in the event of default. From the perspective of an investor, collateral is the asset used by the financial institution to secure your deposit into that financial institution in the event they do not have the ability to pay you the principle and interest due to you at the conclusion of the investment’s term.
When collateral is used as part of an investment contract, it is just as important to have confidence in the value and marketability of the collateral as it is to have confidence in the financial institution itself to complete your investment contract. Collateral comes in many forms but typically the most acceptable of these are U. S. Treasuries and U. S. Agencies. Other potential candidates for collateral include State Agency and Revenue Bonds, School and Municipal Bonds, Tax Anticipation Notes, Highly Rated Out-of-State Municipal Bonds and Highly Rated Corporate Bonds.
Many investors are turning to collateralization as a safety net during these turbulent times. The act of securing a collateral interest in a security is critical to the process for the investor. The investor should have the right to determine what collateral is eligible to be used. In the event the collateral selected has a call feature, you should maintain the right to have only cash or eligible securities used to replace the called security.
Most importantly, a contract must be constructed to secure your interest and establish appropriate custody of the selected collateral. Most financial institutions have such an agreement available, however you should have counsel review the document to verify its perfection of your interest and its enforceability in the event of the failure of the financial institution.
Another issue related to collateralizing an investment is determining the amount of collateral necessary to secure the investment. When using Treasuries and Agencies as collateral, a flat percentage of the investment (collateral margin) is used (103% - 110% is fairly typical). When using collateral with a fluctuating market value, another approach would be to take the current market value plus anticipated interest for the term of the investment, minus FDIC insurance coverage, times the collateral margin you have selected.
When using collateral with a fluctuating market value, it makes perfect sense to have the value reviewed on a daily basis to determine if additional collateral is needed to fully secure your investment. A related issue is the downgrading of the collateral’s rating. The pledge agreement should allow you to replace collateral in the event such a downgrade in ratings occurs.
While establishing collateral and having it properly secured has made your investment more secure, it does not come without a cost. Consider there are legal costs on both sides of these transactions as well as custody and segregation of assets costs to the financial institution. The end result is a secure investment with the potential for a substantially lower returns due to these additional costs.
Other investments exist that are built with supporting assets that may or may not be identified as “collateralized” investments. These investments draw support from assets other than the issuing entity itself. For example, Asset Backed Commercial Paper (ABCP) is supported by assets specifically identified for the issued security. These assets are not necessarily direct assets of the issuer. In many instances these assets are made up of debt that has substantially lower ratings than the issuing entity.
The most widely publicized of these assets are sub-prime mortgages. Thus when an investor purchased ABCP, the name of the issuing entity could have led to the belief that the issuer was supporting the investment. In reality, the supporting asset may have been a pool of sub-prime mortgages. When the sub-prime mortgage market crashed, these pools lost a tremendous amount of value and their ability to support the security issued simply was non-existent or very limited.
The issuing corporation did step in and offer support to these investment vehicles in a number of instances. In many others, losses occurred. Had the investors been experts in evaluating underlying assets, they may have never purchased these securities, or their ongoing credit analyses may have identified the problems before the value was lost. But what business manager has the time and expertise to conduct these analyses?
One of the most effective ways to deal with today’s difficult investment environment is to identify investments with a historic track record of successfully negotiating through difficult financial times. Another approach is to identify an Investment Advisor who is experienced in investing public funds and who also has a history of success in trying times.
Just as importantly, don’t forget what we are going through today when the economy turns around. When times are good it becomes easy to trust the markets to take care of the risks inherent in investing. Our responsibility to exercise good judgment in investment decisions transcends today’s economic difficulties. Understanding your investment options and having confidence in your investment choices will allow you to sleep well each and every night, knowing your investments are appropriate.
This article was written with the assistance of Mark Guastella, Senior Managing Consultant, PFM Asset Management LLC.