Banking for Political Subdivisions Amongst COVID-19
By: D. James Lutter
Financial institutions have been the cornerstone investment vehicle for political subdivisions to generate return. With the onset of the COVID-19 pandemic, the Federal Reserve quickly reduced interest rates to near zero, which had an immediate impact on political subdivisions’ ability to generate returns on investments. As the pandemic continues with no end in sight, the lack of interest income, coupled with increased cost to deal with the pandemic, will have a material impact on political subdivisions’ ability to support services.
In March, the Federal Reserve System reduced overnight interest rates to a range of 0-25bps to stimulate the economy and introduced extensive open market operations to stabilize the financial markets. These programs include the Municipal Liquidity Facility, Primary Market Corporate Credit Facility, Secondary Market Corporate Credit Facility, Money Market Mutual Fund Liquidity Facility, Commercial Paper Funding Facility, The Main Street Lending Program, and Term Asset Backed Securities Facility; each of which is designed to provide backstops and keep the economy from slipping into a depression.
The difference between the Federal Reserve’s responses to the pandemic compared to that of the 2008 Great Recession was in velocity and magnitude. In 2008, the Federal Reserve lowered interest rates to the same level as today, yet there was still opportunity for political subdivisions to invest (0-2 year) in bank product at attractive rates. What was the difference? During the Great Recession, open market operations were implemented to combat issues, whereas during the current pandemic they are being utilized to prevent issues. The credit default risk spiked during the Great Recession in fear of the collapse of the financial markets. Financial institutions tied to LIBOR experienced a spike in rates along with the need to secure liquidity which created a deposit/investment opportunity for political subdivisions. Not the case today, as the Fed, through proactive policy, was able to mediate credit default risk by stabilizing the markets. As a result, LIBOR yields compressed along with Fed Funds. Over the past 20 years, 3-month LIBOR has traded at a positive mean of 27basis points to Effective Fed Funds. During 2008, 3-month LIBOR at a point traded at 224 basis points positive to Effective Fed Funds whereas on August 3, 2020, it is 14 basis points positive to Effective Fed Funds. The result; Fed policy is working to mitigate credit default risk, but severely limits financial institution yield opportunities for political subdivisions.
Additional factors affecting financial institutions’ needs for deposits are corporations drawing on lines of credit along with fiscal stimulus. In 2008, corporate lines of credit were quickly withdrawn financial institutions leaving entities scrambling to secure liquidity. During the current pandemic, corporations were quick to draw on lines of credit and parked the proceeds at financial institutions for emergency liquidity instead of utilizing for business growth. Fiscal stimulus through the Cares Act has also provided liquidity both on the corporate and consumer side through financial aid. The financial aid has largely been parked at financial institutions as we’ve witnessed an increase in savings rate of 25% since the onset of the pandemic. The result is enhanced liquidity at financial institutions further limiting their need for additional funding. Financial institutions are over funded by upwards of $3 trillion along with an expanded Fed balance sheet of nearly $7 trillion.
Historically, money centers and larger regional banks price from a market-based index such as LIBOR whereas community banks typically price from a Fed Funds-based model. The different pricing models allow for opportunity through the various economic cycles, yet through aggressive Fed policy the spread has substantially compressed.
During the current market environment, it is critical to stay focused on credit first, liquidity then yield. With financial institution deposits, making sure the proper securitization is in place per investment policy and state statute is critical. Financial institutions are still, and will remain, the cornerstone of services and investments for political subdivisions. The key will be to understand the funding needs of your local financial institution and be willing to expand the footprint to other institutions to help fill in the gap. The investment process will most likely take longer and you will need to be willing to work with a larger population of institutions to maximize return during the current environment.
About D. James Lutter
D. James (Jim) Lutter is the Senior Vice President of Funding and Trading and at PMA Financial Network and PMA Securities where he oversees PMA Funding, a service of both companies that provides over 1,000 financial institutions with a broad array of cost effective funding alternatives. Mr. Lutter is a Registered Representative with PMA Securities and Investment Advisor Representative with PMA Asset Management. Mr. Lutter has the following FINRA licenses with PMA Securities, LLC: Series 7, 24, 50, 53, 63, 65 and 99.
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