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HomeMy WebLinkAboutFinance Committee reportFINANCE COMMITTEE City of Miami, Florida February 20, 2014 REPORT TO THE CITY COMMISSION OF FINDINGS AND RECOMMENDATIONS CONCERNING INVESTMENT POLICIES AND PRACTICES A. Summary This is the report of the City of Miami's Investment Committee' concerning investment decisions made through June 2013 that have left the City's portfolio of investments in a highly unfavorable condition and in apparent conflict with the requirements of the City of Miami's Investment Policy.2 It is important to recognize that we are talking in this Report about the City as the investor of cash it is holding, not as the issuer of bonds to raise cash. Based on an inquiry by one of the Finance Committee members, in cooperation with the City's Chief Financial Officer, members of the Finance Department, and the City Attorney's Office, this report sets forth the Committee's findings and recommendations concerning how the City found itself in this highly unfavorable situation. It also discusses other issues that became apparent when the Committee looked into the situation. Finally, it contains recommendations for modifying procedures and policies going forward. 'Pursuant to City Commission Resolution No. 98-63, as amended, the Finance Committee of the City of Miami exists to review and make recommendations regarding the issuance of debt obligations and the management of outstanding debt; City Risk Management and Insurance; City Compensation, Benefits, and Pensions; City Financial matters; City Debt Restructuring; City Investments; City Financial Consultants; and all matters related to, allied with, or incidental to any of the foregoing. The Committee is composed of citizens appointed by the Mayor and the City Commissioners. The City Manager is represented on the Committee by the Finance Director. 2Exhibit 1 to this Report is a copy of the Investment Policy, last amended in 2007. As stated in the Investment Policy, its "purpose ... is to set forth the investment objectives and parameters for the management of public funds of the City of Miami... These policies are designed to safeguard the City's funds, the availability of operating and capital funds when needed, and an investment return competitive with comparable funds and financial market indices." The unfavorable condition in which the City finds itself is two -fold in nature. First, the City currently owns $271 million face amount of bonds, which were worth $266 million at the end of 2013 -- unrealized ("paper") losses of approximately $5,000,000.3 These bonds were bought between June 2012 and June 2013.4 The losses were caused by a significant increase in market interest rates5 starting May 2, 2013.6 It is 3 An "unrealized" loss occurs when there is a drop in the value of the bond but no sale occurs. A "realized" loss occurs when the bond is sold for less than what the holder paid for the bond. Unrealized losses are sometimes referred to as "paper" losses. 4 Exhibit 2 to this Report is a chart showing the important details concerning each bond in the City's portfolio as of December 31, 2013. The bonds listed remain in the City's portfolio. Notably, listings such as Exhibit 2 are posted on the City's website as part of the City's Monthly Financial Repot, available at http://www.miamigov.com/- Finance/pages/Financiallnfo/financiallnfo.asp. The monthly listings of investments posted on the Web do not include the last two columns of infoiiiiation, market value and gain/loss. That said, on another page of the Monthly Financial Report the aggregate book value and market value of the City's bonds are listed, allowing the reader to calculate for himself or herself the unrealized gain or loss in the portfolio. The Committee urges the Finance Department to publish on the Web the market value and gain/loss in each position, particularly since this is the format in which the data are provided to officials within the City Government. 5"Market interest rate" refers to the current yield of an existing bond trading in the financial markets. Market interest rates on bonds fluctuate over time. When rates rise, it is because buyers of bonds are demanding greater return for their money. When rates fall, it is because buyers of bonds are willing to settle for lower return for their money. Buyers of bonds take into consideration numerous factors, including their expectations concerning the future direction of levels of inflation. We will use the term "market interest rate" to distinguish from coupon rate, which is the amount of interest per year the issuer of a bond agrees to pay on the bond. By contrast to market interest rates, coupon rates stay the same throughout the life of the bond. Market interest rates discussed in this report are "Constant Maturity Treasury" rates published daily by the Department of the Treasury. http://www.treasury.gov/resource- center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield. They represent a daily determination by the Treasury, based on interest rate market data, of what the yield on. U.S. Treasury bills, notes, and bonds of different maturities would be if they were issued on that day. 6 Exhibit 3 shows market interest rates for 5-year Government bonds from September 2012 to December 2013. 2 noteworthy that while the absolute increase in market interest rates for 5-year bonds from May 2, 2013 (0.65%) to December 31, 2013 (1.75%) was 1.1%, or 110 basis points, the relative increase (the percentage of the interest rates as of May 2, 2013 by which rates later increased) was 169% through the end of 2013. Interest rates have trended down during 2014, reducing the unrealized loss on the City's bonds. As of December 31, 2013, the Constant Treasury Maturity rate for 5-year rates was 1.75%; as of February 18, 2014, it was 1.50%, still 85 basis points above the rate at May 1, 2013. Second, because the particular bonds that were in the portfolio when market interest rates began to rise were 5-year bonds of different maturities,' the City will be locked into its current portfolio until their maturity (as of mid -February 2014, approximately 3-1/2 to 4 years), absent a decrease in market interest rates of the same magnitude as the increase in market interest rates since May 2, 2013. Likewise, with such a decrease in market interest rates, the City will have to take a realized (actual) loss on bonds it sells if it needs to sell bonds to fund large expenditures. This already happened in September 2013 and is forecasted to happen again unless interest rates fall substantially. Of course, if market interest rates were to fall enough that the value of bonds in the City's portfolio rise to the same level as when they were purchased, the City would be able to sell the bonds without a loss. The situation in which the City finds itself would have been avoided had the City followed the plain mandates set forth in the City's Investment Policy designed to avoid just such a situation. At least for the past six years, the City has been following the strategy of "chasing yield," i.e., seeking elevated returns on its investments over what it could earn if it limited its investments to shorter maturity bonds with lower coupons and less inherent risk. The strategy followed by the City has resulted in a violation of one of the basic tenets of the City's own Investment Policy, which requires that investments be safe and liquid (easily sold without loss), and specifically states that yield, or return, is far less important than safety and liquidity and should not be sought so as to jeopardize either of those primary goals. We discuss the Investment Policy in more detail below. It is important to note that the bonds in the City's portfolio were bought between June 2012 and June 2013, at a time when there were permanent vacancies in virtually all leadership positions within the City's Finance Department and none of the current senior leadership were working in the Department. The remaining employees were left with the responsibility to make investment decisions without the ability to make these decisions through internal discussions, as the Investment Policy specifically contemplates. Allowing such vacancies to occur and not filling them promptly enough was a serious problem that may have been a contributing factor in producing the current problems in the City's investment portfolio. 7 We have ignored the technical difference between "duration" and maturity" because we believe it is immaterial to this Report. 3 Finally, despite there having been no loss, realized or unrealized, until mid-2013, the Committee has concerns about the adequacy of the City's disclosure of its interest rate risk — the risk that the value of its investments will be affected by changes in interest rates — in previously issued Comprehensive Annual Financial Reports (CAFRs), which concerns are already being addressed by the City's Chief Financial Officer and Finance Department. At the end of this report we summarize the resolutions the Finance Committee has passed in an attempt to help the City avoid such situations in the future. Fundamentally, the City's Investment Policy should be respected at all levels of the City's Government. The Finance Department should be understood to be a "cost center," not a "profit center." The Finance Department is responsible for investing the City's funds prudently and safely, with minimal attention to yield and primary attention to safety and liquidity. The Finance Department must never be put in the position where it is expected to "chase yield." This will only result in future problems such as the City now faces. B. Findings 1. Provisions of the Investment Policy Concerning Investment Objectives The City's Investment Policy is approved by the City Commission.8 Section III of the Policy ranks the objectives of the City's investment program. "The foremost objective of this investment program is the safety of the principal of those funds within the portfolios. Investment transactions shall seek to keep capital losses at a minimum, whether they are from securities defaults or erosion of market value. The next most important factor is liquidity: "The portfolios shall be managed in such a manner that funds are available to meet reasonably anticipated cash flow requirements in an orderly manner. Periodical cash flow analyses will be completed in order to ensure that the portfolios are positioned to provide sufficient liquidity."9 Lastly, the Policy discusses return on investments: Investment portfolios shall be designed with the objective of attaining a market rate of return throughout budgetary and economic cycles, taking 8 Responsible City officials are currently working with the City's investment adviser on revisions to the Investment Policy. Eventually the proposed new Investment Policy will be presented to the City Commission for its consideration. 9 The City's Investment Policy, Glossary of Teiins, defines liquidity thus: "A liquid asset is one that can be converted easily and rapidly into cash without a substantial loss of value." 4 into account the investment risk constraints and liquidity needs. Return on investment is of least importance compared to the safety and liquidity objectives described above. The core of investments is limited to relatively low risk securities in anticipation of earning a fair return relative to the risk being assumed. (emphasis added) In other words, the City is told to buy safe investments, to make sure they can be sold without a loss when needed to fund expenses, and not to chase yield. In addition, Section X of the Investment Policy states, in Section XII: "To the extent possible, an attempt will be made to match investment maturities with known cash needs and anticipated cash flow requirements." Finally, it states: "Securities purchased by or on behalf of the City shall have a final maturity of five (5) years or less from the date of purchase. The overall weighted average duration of principal return for the portfolio shall be less than three (3) years."10 2. The City's Search for Higher Returns Like any investor, the City has many choices as to what it can do with the cash it collects from user fees, taxes, and the like. Generally, the choices it makes are dictated by the investment objectives it chooses to follow. The City's investment objectives are set in the Investment Policy: first, safety, second, liquidity, and third, return on investment (without interfering with the first two goals). The City has not made unsafe investments: it has not, for example, bought corporate junk bonds. The second goal, liquidity, is determined primarily by the maturity of the bond, i.e., when it will be repaid. That is because the longer the bond, the more sensitive it is to rises and falls in market interest rates. In other words, at any one time, when market interest rates rise or fall, the value of a 5-year bond will fall or rise, as a percentage of value, substantially more than the value of a 1-year bond. Exhibit 4 illustrates this fact by showing changes in interest rates for 5-year Treasury bonds compared to 1-year bonds from 2011 to January 2014. As can be seen, 5-year market interest rates fluctuated to a far greater extent than 1-year rates during the same period of time when market interest rates changed. l 1 10 The Policy does not specify whether the 3- and 5-year duration (maturity) requirements refer only to investments (bonds and commercial paper) or to investments and cash and cash equivalents (including money market funds), but it is understood that the requirements are to investments exclusive of cash. u Bonds have three yields: coupon (the bond interest rate fixed at issuance), current (the bond interest rate as a percentage of the current price of the bond), and yield to maturity (an estimate of what an investor will receive if the bond is held to its maturity date). Current yield rises when market interest rates rise, while bond values fall. when market interest rates rise. Current yield falls when market interest rates fall., while bond values rise when market interest rates fall. 5 Coupon yields (the bond's interest rate fixed at issuance) generally increase as the length of bonds increases. In other words, a 5-year Treasury bond will have a higher coupon rate than a 1-year Treasury bond. In addition, "callable" bonds, which can be called or redeemed by the issuer at set times, offer a higher coupon rate than non -callable bonds of the same length -- but are subject to risks for the investor not present in non - callable bonds. The City, as an investor, has been seeking greater returns in both respects. First, since 2008, it has been buying bonds of ever-increasing maturities. The bonds added to the City's portfolio from June 2012 to June 201312 have been 5-year bonds, the maximum duration permitted under the Investment Policy. Because the longer the bond, the greater the coupon rate, this increase in maturities has led to greater returns at greater risk. Second, since at least 2008, all bonds bought by the City have been callable bonds. Another boost in yield came from the City's purchase, since at least 2005, of callable bonds issued by Government Sponsored Entities ("GSE") such as Fannie Mae and Freddie Mac, which carry higher coupon rates than non -callable bonds of the same maturity. (Such bonds are often called "Agencies.") This higher yield stems from two factors: first, the fact that the Agencies are callable means that if interest rates drop, they will be called (the issuer will force the holder of the bonds to sell them), and the holder will be deprived of the greater return over the nominal life of the bond; second, Agencies are not explicitly backed by the full faith and credit of the U.S. Government, which increases the theoretical risk of default. Both of these factors result in a higher coupon rate for callable Agencies than for Treasury notes or bonds of the same maturity. In addition, as with all bonds, the longer the bond, the higher the coupon rate. Moreover, Agencies are more volatile than Treasury bonds: they react more to changes in interest rates. The issuer of callable bonds pays a higher coupon rate in order to call the bonds at pre -established intervals. In general, if interest rates fall, then the bonds are called, the issuer gets to refinance its debt at a lower interest rate, and the holder has to reinvest its investable funds at a lower interest rate. We have not attempted determine whether, using the complex mathematical formulae applied to valuing callable bonds, the risk of being called away when the City's bond maturities were low (2008-2010) was outweighed by the benefit of higher returns. Nevertheless, when the City began increasing the length of the callable bonds it was buying, the risk associated with a rise of interest rates increased. The increase in the length of the City's bonds is shown in Exhibit 4, which plots "weighted average duration" of the City's investments and cash, on an annual basis, from September 30, 2008 to September 30, 2013 (the latest available date for which information was available from the City). As previously noted, the City's Investment Policy requires that the weighted average duration of the City's investments must be less 12 No new purchases of bonds have occurred since June 2013. 6 than 3 years. According to City records, the three-year upper limit was breached towards the end of the fiscal year ended September 30, 2013. Unquestionably, buying bonds of greater length has its benefits: the longer the bond, the higher the coupon rate, which means more interest received per year over the life of the bond than from bonds of a shorter maturity. With the purchase of bonds of longer maturity, however, comes increased risk, in the form of increased sensitivity to changes in market interest rates. As discussed above, when market interest rates rise (as could reasonably have been expected throughout this period), bonds of a longer maturity lose more of their value than bonds of a shorter maturity.13 In other words, the callable feature aside, buying bonds of increasing maturity was an ever -riskier gamble that interest rates would not rise. The callable feature merely increased the risk associated with higher interest rates by causing a larger drop in value than non -callable bonds of the same portfolio. The City's Investment Policy provided clear guidelines, which quite apparently have not been adhered to in recent years. The chickens came home to roost in May 2013, when interest rates started a major increase, which was immediately reflected in unrealized — paper — losses in the City's bond portfolio. But the risk was there all along, and was increasing over time. It is the Committee's view, and bears repeating, that the City should not be gambling on interest rate movements to increase yield. No one knows where rates are going — ever. There is no of knowing whether interest rates will rise or fall, or when, or by how much. All we know is that they will rise or fall. To illustrate the point, because interest rates have dropped since December 31, 2013, the unrealized loss as of February 14, 2014 is less than the $4,880,000 unrealized loss at year-end. But next week the loss may rise to $6,000,000 (or higher), if interest rates rise again. The important point today is that unless interest rates drop by roughly approximately 100 basis points, or 1 %, the City will be locked into these bonds for another 3 to 4 years.14 13 Of course, the converse is also true: if market interest rates fall, long-term bonds gain more value than short-term bonds. 14 Eventually, as durations decrease, the City's bond portfolio will show increasingly less sensitivity to interest rate changes. We are several years away, however, from the point where prevailing interest rates will, by reason of the shorter durations alone, make it possible to sell bonds with a significantly smaller loss than at the present time. 7 3. Further Observations a. Effect of Vacancies Critically, during the period in which the GSE Bonds were purchased in 2012 and 2013, the Finance Department was severely short-handed at all levels: vacancies existed, in among other positions, of Finance Director, Assistant Finance Director and Treasurer, and the City's Chief Financial Officer was serving as acting Finance Director. In addition, many "line" operational positions were vacant. The acting Finance Director's attention was apparently primarily focused on other matters, especially the city's accounting and reporting function and the completion of the comprehensive annual financial report ("CAFR"). The individual left with the responsibility for making investments has informed the Committee that he was further limited in his ability to discuss these investment decisions by an oral directive in mid -December 2012 from the City's then Chief Financial Officer and acting Finance Director not to communicate with the City's then sole Financial Advisor, FirstSouthwest Company. According to this individual, he was therefore put in the position of making investment decisions by himself: he characterized his position as one of having "no one to talk to." It is obvious he was not trained for this increased responsibility. As noted, the length of bonds purchased after June 2012 increased to 5 years at the very time the Finance Department was most shorthanded. Further inquiry will be required to determine the actual events that caused increases in the maturities of bonds being purchased. In any event, the assumption that interest rates would continue to remain stable or would drop would have been the only logical explanation for buying callable 5-year bonds at that time, and, although this had been the trend for almost 2-1/2 years, this assumption turned out to be very wrong. The City should take all possible steps not to allow the existence of so many vacancies in the Finance Department as occurred in 2012 and 2013. The Finance Department was stretched thin No one in a position of authority was left to oversee investment decisions, as a result of which the City continued to buy callable Agencies at longer and longer maturities.15 No Department should be peiiuitted to operate with such a level of vacancies. Effective executive leadership in any organization is required to set priorities and manage operations effectively, efficiently and prudently. 15 According to the Investment Policy, Section XV.C, there is supposed to be an Investment Committee within the Department, composed of the Director, Assistant Director, and Treasurer. The Committee is empowered by Section XII to tighten the permissible range of permissible investments based on, among other factors, market conditions. During the 2012-2013 period, all of these positions were vacant or were held by individuals with other job titles with multiple responsibilities. 8 b. Sale of Some Agencies at Loss In October 2013, the City took the opportunity to pay on a timely basis its actuarially determined Annual Required Contributions (ARC) to the FIPO and GESE Pension Plans. The Actuaries calculate the annual amount due as of October 1 of the fiscal year. The City had typically paid the contribution in December or more than two months late to coincide with the cash influx from property tax revenues. Paying late meant the City had to pay the returns the Plans would have received for the 60 or more days from October 1 to the date of payment. Since the actuarially stated annual rates of return for FIPO and GESE were 7.5% and 8.1%, respectively, and the FIPO ARC was $41,927,900 and the GESE ARC $30,710,096, the City would have had to pay an additional amount of approximately $938,000 in interim returns had it chosen to make the ARCs on the typical late basis. By paying on time in October, and not having to pay the interim accrued interest, the City saved over $900,000. The ARC payments were made from a combination of cash on hand and the proceeds from the sale of $30,000,000 in Agencies. Had the City used solely cash on hand. in September, the cash levels would have been brought too low to sustain operations until the December influx. It was the joint decision of the City's Finance and Budget Departments in conjunction with the City Manager's Office to make the ARC payments in September and effect these savings. In the Committee's judgment, although the Agencies were sold at a $119,000 loss, which reduced the savings, the decision of the City's management cannot fairly be faulted. The problem is not with this decision, but rather with the fact that the City had previously bought bonds that were excessively vulnerable to the large rise in market interest rates. It should be noted that, according to current cash flow projections, in September 2014 the City will again need to "break a bond" at a loss in order to take make the 2014 ARC payments on time. c. Disclosure Issues As part of the Committee's review of this situation, it considered the City's disclosure of interest rate risk in the financial statements contained in the September 30, 2012 CAFR, and in prior years. The Governmental Accounting Standards Board (GASB) is the independent organization that establishes and improves standards of accounting and financial reporting for U.S. state and local governments. Established in 1984 by agreement of the Financial Accounting Foundation (FAF) and 10 national associations of state and local government officials, the GASB is recognized by governments, the accounting industry, and the capital markets as the official source of generally accepted accounting principles (GAAP) for state and local governments. The City represents that the audited financial statements contained in its CAFRs are prepared in accordance with GASB standards. 9 GASB Statement No. 40 ("Deposit and Investment Risk Disclosures") covers the disclosure of information concerning the interest rate risk of its debt securities.16 "Interest rate risk" is defined by GASB as "[t]he risk that changes in interest rates will adversely affect the fair value of an investment." Exhibit 5 is a copy of relevant excerpts from Statement No. 40.17 In brief, Statement No. 40 requires "disclosure of information about the interest rate risk of their debt," including "the terms of investments with fair values that are highly sensitive to changes in interest rates." Statement No. 40 permits the disclosure of interest rate risk to be organized by weighted average maturity, as the City has done, but further states that "[i]f a method requires an assumption regarding timing of cash flows (for example, whether an investment is or is not assumed to be called), interest rate changes, or other factors that affect interest rate risk information, that assumption should be disclosed." The use of the weighted average maturity method likely implicates the additional disclosure requirements concerning the underlying assumptions timing of cash flows, interest rate changes, and other factors that affect interest rate risk information." The Finance Department has indicated to the Committee that it concurs with this conclusion. The City's disclosure on this subject in the September 30, 2012 financial statements was as follows: Interest rate risk is the risk that as market rates change, the fair value of an investment will vary. Generally, the longer the maturity of an investment, the greater the sensitivity of its fair value to changes in the market interest rates. The City's policy limits the maturity of an investment to a maximum of 5 years. As of September 30, 2012, the City of Miami had the following investments with the respective weighted average maturity in years. The respective weighted average maturities were based on the securities' call date, not the maturity date. (emphasis added) 16 Disclosure of interest rate risk is contained in the notes to the financial statements. "The notes to the financial statements present both quantitative and narrative information. that is essential to a financial statement user's understanding of financial position or inflows and outflows of resources. In other words, the notes are necessary to comprehending what the financial statements are trying to communicate." GASB, The Relationship between Financial Statements and Notes, available at http://www. gasb.org/j sp/GA.SB/GASBContent_C/UsersArticlePage&cid=1.1761.5672243 0. As a result, it is customarily stated in financial statements presented in accordance with GAAP, including the City's, that "[t]he accompanying notes are an integral part of the financial statements." 17 Because of its length, the entirety of Statement No. 40 is not including in Exhibit 5. The full text of Statement No. 40 is available at http://www.gasb.org/jsp/GASB/Page/- GASB SectionPage&cid=1176160042391 #gasbs50. 10 The City then disclosed the weighted average maturity of the different types of investments held at September 30, 2012. These showed the weighted average maturities of the GSE bonds between .33 years and 1.19 years, based on the securities' call date, not the maturity date.) 8 The Committee understands that the Finance Department, in preparing for the issuance of the September 2013 CAFR, and, through the City Attorney's Office, will request the assistance from disclosure counsel in considering CAFR disclosure of interest rate risk, including whether disclosure of interest rate risk should include (i) the weighted average maturity of the entire investment portfolio or (ii) the weighted average maturity, based on maturity date, of callable bonds and of the entire investment portfolio, (iii) the assumptions concerning callable bonds, i.e., whether the investments are assumed to be called, (iv) interest rate changes that could affect whether they would likely be called, and (v) whether the chosen method of disclosure is most consistent with the method the City uses to identify and manage interest rate risk. The Committee feels that review should also be made of whether the footnote disclosure referring to the City's Investment Policy limit on the maturity "of an investment to a maximum of 5 years," should be expanded to disclose the requirement in the Policy that the weighted average maturity of all investments be a maximum of 3 years.19 4. Recommendations In light of the importance of disclosure in CAFRs, as evidenced by recent developments in the enforcement program of the Securities and Exchange Commission with respect to municipalities' continuous (non -bond -issue -related) disclosures, the Committee recommends that the City Commission direct the City Attorney to engage independent expert disclosure counsel to review or assist in the preparation of disclosures in CAFRs (beyond the limited areas of descriptions of City litigation or legal descriptions of debt documents and financings). Although the City Attorney currently has authorization to engage Bond and Disclosure Counsel to assist with bond financings, the City Attorney has not been directed to engage counsel with respect to CAFR disclosure. 18 Disclosure of interest rate risk in the same format was made in CAFRs since at least 2005, when the requirement in GASB Statement No. 40 to disclose interest rate risk came into effect. 19 Another possible issue is the reasonableness of disclosing the weighted average maturity based on call date when, at the time the CAFR is issued, market interest rates have risen and there is no likelihood of the bonds being called absent a subsequent large drop in interest rates. It should be noted that in the case of the September 30, 2012 CAFR, the report date of the audit report of the City's independent accountants was June 20, 2013, the approximate date of the issuance of the CAFR, by which time interest rates had risen dramatically, the City's bonds were approximately $4,500,000 under water, and there was no reasonable likelihood that the bonds would be called in the foreseeable future. 11 The Committee believes that this will strengthen the ability of the City to make appropriate disclosures in CAFRs. The Committee recommends to the City Commission that it give the Finance Department the authority to engage, on an as -needed basis, an outside CPA with experience in Governmental Accounting Standards, to assist the City with respect to accounting and financial reporting issues.20 The Committee recommends that the City Commission direct the City's Independent Auditor General to conduct an investigation of the facts and circumstances that led to the current situation with the City's bond investments, including interest rate risk disclosure issues and investment processes. Finally, all officials, elected and appointed, in the City Government must understand and respect the purpose of the Finance Department, which, according to the City Charter, is to manage and invest public funds. All should understand that "chasing yield" carries inappropriate risks that threaten the liquidity (and, at the extreme, the safety) of city investments. In short, the Finance Department must be required, and permitted, to invest the City's money prudently and strictly in accordance with the City's Investment Policy. The City's investments should not be used to create extra profit to help balance the budget. The watchwords of safety and liquidity are already in the Investment Policy, and the City must follow the Policy. We now know what happens when it does not. The findings, views and opinions expressed in this Report are solely those of the City of Miami Finance Committee, and do not necessarily reflect those of the Mayor, individual City Commissioners, the City Manager, or the City Attorney of the City of Miami. 20 The newly hired senior officials of the City's Finance Department all have experience in GASB-based accounting. The Committee's recommendation in this respect is not meant to question the integrity or qualifications of these individuals, but merely to provide an independent source of analysis of the adequacy of past CAFR disclosures concerning interest rate risk. 12 Exhibit 1 to FINANCE COMMITTEE REPORT ON CITY INVESTMENTS CITY OF MIAMI INVESTMENT POLICY AUGUST 23, 2007 Table of Contents Page I. PURPOSE 3 II. SCOPE 3 III. INVESTMENT OBJECTIVES 3 IV. DELEGATION OF AUTHORITY 4 V. STANDARDS OF PRUDENCE 4 VI. ETHICS AND CONFLICTS OF INTEREST 5 VII. INTERNAL CONTROLS AND INVESTMENT PROCEDURES 5 VIII. CONTINUING EDUCATION 5 IX. AUTHORIZED INVESTMENT INSTITUTIONS AND DEALERS 5 X. MATURITY AND LIQUIDITY REQUIREMENTS 6 XI. COMPETITIVE SELECTION OF INVESTMENT INSTRUMENTS 6 XII. AUTHORIZED INVESTMENTS AND PORTFOLIO COMPOSITION 7 XIII. DERIVATIVES AND REVERSE REPURCHASE AGREEMENTS 14 XIV. PERFORMANCE MEASUREMENTS 15 XV. REPORTING 15 XVI. THIRD -PARTY CUSTODIAL AGREEMENTS 16 XVII. INVESTMENT POLICY ADOPTION 16 XVIII. GLOSSARY OF TERMS 17 City of Miami Investment Policy Page 2 Investment Policy City of Miami, Florida I. PURPOSE The purpose of this policy is to set forth the investment objectives and parameters for the management of public funds of the City of Miami, Florida (hereinafter "City"). These policies are designed to safeguard the City's funds, the availability of operating and capital funds when needed, and an investment return competitive with comparable funds and financial market indices. II. SCOPE In accordance with Section 218.415, Florida Statues, this investment policy applies to all cash and investments held or controlled by the City and shall be identified as "general operating funds" of the City with the exception of the City's Pension Funds, Deferred Compensation & Section 401(a) Plans, and funds related to the issuance of debt where there are other existing policies or indentures in effect for such funds. Additionally, any future revenues, which have statutory investment requirements conflicting with this Investment Policy and funds held by state agencies (e.g., Department of Revenue), are not subject to the provisions of this policy. III. INVESTMENT OBJECTIVES Safety of Principal The foremost objective of this investment program is the safety of the principal of those funds within the portfolios. Investment transactions shall seek to keep capital losses at a minimum, whether they are from securities defaults or erosion of market value. To attain this objective, diversification is required in order that potential losses on individual securities do not exceed the income generated from the remainder of the portfolio. From time to time, securities may be traded for other similar securities to improve yield, maturity or credit risk. For these transactions, a loss may be incurred for accounting purposes, provided any of the following occurs with respect to the replacement security: A. Yield has been increased, or B. Maturity has been reduced, or lengthen C. Quality of the investment has been improved. City of Miami Investment Policy Page 3 Maintenance of Liquidity The portfolios shall be managed in such a manner that funds are available to meet reasonably anticipated cash flow requirements in an orderly manner Periodical cash flow analyses will be completed in order to ensure that the portfolios are positioned to provide sufficient liquidity. Return on Investment Investment portfolios shall be designed with the objective of attaining a market rate of return throughout budgetary and economic cycles, taking into account the investment risk constraints and liquidity needs. Return on investment is of least importance compared to the safety and liquidity objectives described above. The core of investments is limited to relatively low risk securities in anticipation of earning a fair return relative to the risk being assumed. IV. DELEGATION OF AUTHORITY In accordance with the City's Administrative Policies, the responsibility for providing oversight and direction in regard to the management of the investment program resides with the City's Finance Director. The management responsibility for all City funds in the investment program and investment transactions is delegated to the Finance Director or designee. The Finance Director shall establish written procedures for the operation of the investment portfolio and a system of internal accounting and administrative controls to regulate the activities of employees. The City may employ an Investment Advisor to assist in managing some of the City's portfolios. Such Investment Advisor must be registered under the Investment Advisors Act of 1940. V. STANDARDS OF PRUDENCE The standard of prudence to be used by investment officials shall be the "Prudent Person" standard and shall be applied in the context of managing the overall investment program. Investment officers acting in accordance with written procedures and this investment policy and exercising due diligence shall be relieved of personal responsibility for an individual security's credit risk or market price changes, provided deviations from expectation are reported to the Director of Finance in a timely fashion and the liquidity and the sale of securities are carried out in accordance with the terms of this policy. The "Prudent Person" rule states the following: Investments shall be made with judgment and care, under circumstances then prevailing, which persons of prudence, discretion and intelligence exercise in the management of their own affairs, not for speculation, but for investment, considering the probable safety of their capital as well as the probable income to be derived from the investment. While the standard of prudence to be used by investment officials who are officers or employees is the "Prudent Person" standard, any person or firm hired or retained to invest, monitor, or advise concerning these assets shall be held to the higher standard of "Prudent Expert". The standard shall be that in investing and reinvesting moneys and in acquiring, retaining, managing, and disposing of investments of these funds, the contractor shall exercise: the judgment, care, skill, prudence, and diligence under the circumstances then prevailing, which persons of prudence, discretion, and intelligence, acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of like character and with like aims by diversifying the investments of the funds, so as to minimize the risk, considering the probable income as well as the probable safety of their capital. City of Miami Investment Policy Page 4 VI. ETHICS AND CONFLICTS OF INTEREST Employees involved in the investment process shall refrain from personal business activity that could conflict with proper execution of the investment program, or which could impair their ability to make impartial investment decisions. Also, employees involved in the investment process shall disclose to the City Manager any material financial interests in financial institutions that conduct business with the City, and they shall further disclose any material personal financial/investment positions that could be related to the performance of the City's investment program. VII. INTERNAL CONTROLS AND INVESTMENT PROCEDURES The Finance Director shall establish a system of internal controls and operational procedures that are in writing and made a part of the City's operational procedures. The internal controls should be designed to prevent losses of funds, which might arise from fraud, employee error, and misrepresentation, by third parties, or imprudent actions by employees. The written procedures should include reference to safekeeping, repurchase agreements, separation of transaction authority from accounting and recordkeeping, wire transfer agreements, banking service contracts, collateral/depository agreements, and "delivery -vs -payment" procedures. No person may engage in an investment transaction except as authorized under the terms of this policy. Independent auditors as a normal part of the annual financial audit to the City shall conduct a review of the system of internal controls to ensure compliance with policies and procedures. VIII. CONTINUING EDUCATION The Finance Director, Treasurer, and appropriate staff shall annually complete 8 hours of continuing education in subjects or courses of study related to investment practices and products. IX. AUTHORIZED INVESTMENT INSTITUTIONS AND DEALERS Authorized City staff shall only purchase securities from the following financial and investment institutions. A. Certificates of Deposit or Savings Accounts These investments may only be purchased from public depositories qualified by the Treasurer of the State of Florida, in accordance with Chapter 280, Florida Statutes. B. Overnight Repurchase Agreement Collateral for the City's "Sweep Accounts" shall be held at City's depository bank that must be a State Qualified Public Depository. City of Miami Investment Policy Page 5 C. All Other Investments For purchases and sales of securities by the City, dealers designated as "Primary Securities Dealers" by the Federal Reserve Bank of New York or from direct issuers of connnercial paper and bankers' acceptances will be utilized, and all approved non -primary securities dealers that qualify under Securities and Exchange Commission Rule 15C3-1 (uniform net capital rule) must provide the following information prior to executing investment trades with the City: 1. Annual financial statement, as well as most recent quarterly statement. 2. Regulatory history, through either the Office of the Comptroller of the Currency for dealer banks, or the NASD for securities firms. 3. Statement of any pending lawsuits materially affecting the firm's business. Each Dealer's representative will be required to complete the "City's Investment Firm Certification Form" prior to the City conducting any business with the Dealer or its representative. X. MATURITY AND LIQUIDITY REQUIREMENTS To the extent possible, an attempt will be made to match investment maturities with known cash needs and anticipated cash flow requirements. A. Maturity Guidelines Securities purchased by or on behalf of the City shall have a final maturity of five (5) years or less from the date of purchase. The overall weighted average duration of principal return for the portfolio shall be less than three (3) years. The maturities of the underlying securities of a repurchase agreement will follow the requirements of the Master Repurchase Agreement. B. Liquidity Requirements In order to meet the day-to-day expenditure needs of the City, $3,000,000 will be the targeted cash balance in the City's depository bank. All funds in the depository bank will be "swept" each night into a fully collateralized repurchase agreement account. XI. COMPETITIVE SELECTION OF INVESTMENT INSTRUMENTS After the Finance Director or Designee has determined the approximate maturity date based on cash flow needs and market conditions and has analyzed and selected one or more optimal types of investments, a minimum of three (3) qualified banks and/or approved broker/dealers must be contacted and asked to provide bids/offers on securities in questions. Bids will be held in confidence until the bid deemed to best meet the investment objectives is determined and selected. However, if obtaining bids/offers are not feasible and appropriate, securities may be purchased utilizing the comparison to current market price method on an exception basis. Acceptable current market price providers include, but are not limited to: A. Telerate Information System City of Miami Investment Policy Page 6 B. Bloomberg Information Systems C. Wall Street Journal or a comparable nationally recognized financial publication providing daily market pricing D. Daily market pricing provided by the City's custodian or their correspondent institutions The Finance Director or designee shall utilize the competitive bid process to select the securities to be purchased or sold. Selection by comparison to a current market price, as indicated above, shall only be utilized when, in judgment of the Finance Director or designee, competitive bidding would inhibit the selection process. Examples of when this method may be used include: A. When time constraints due to unusual circumstances preclude the use of the competitive bidding process B. When no active market exists for the issue being traded due to the age or depth of the issue C. When a security is unique to a single dealer, for example, a private placement D. When the transaction involves new issues or issues in the "when issued" market Overnight sweep repurchase agreements will not be bid, but may be placed with the City's depository bank relating to the demand account for which the repurchase agreement was purchased. XII. AUTHORIZED INVESTMENTS AND PORTFOLIO COMPOSITION Investments should be made subject to the cash flow needs and such cash flows are subject to revisions as market conditions and the City's needs change. However, when the invested funds are needed in whole or in part for the purpose originally intended or for more optimal investments, the Finance Director or designee may sell the investment at the then -prevailing market price and place the proceeds into the proper account at the City's custodian. The following are the investment requirements and allocation limits on security types, issuers, and maturities as established by the City. Diversification strategies within the established guidelines shall be reviewed and revised periodically as necessary by the Investment Committee. The Investment Committee, Director of Finance or designee shall have the option to further restrict investment percentages from time to time based on market conditions, risk and diversification investment strategies. The percentage allocations requirements for investment types and issuers are calculated based on the original cost of each investment. Investments not listed in this policy are prohibited. A. The Florida Local Government Surplus Funds Trust Fund ("SBA") 1. Investment Authorization The Finance Director or designee may invest in the SBA. City of Miami Investment Policy Page 7 2. Portfolio Composition A maximum of 100% of available funds may be invested in the SBA. B. United States Government Securities 1. Purchase Authorization The Finance Director or designee may invest in negotiable direct obligations, or obligations the principal and interest of which are unconditionally guaranteed by the United States Government. Such securities will include, but not be limited to the following: Cash Management Bills Treasury Securities — State and Local Government Series ("SLGS") Treasury Bills Treasury Notes Treasury Bonds Treasury Strips 2. Portfolio Composition A maximum of 100% of available funds may be invested in the United States Government Securities with the exception of Treasury Strips are limited to 10% of available funds. 3. Maturity Limitations The maximum length to maturity of any direct investment in the United States Government Securities is five (5) years from the date of purchase. C. United States Government Agencies 1 Purchase Authorization City of Miami The Finance Director or designee may invest in bonds, debentures, notes or callables issued or guaranteed by the United States Governments agencies, provided such obligations are backed by the full faith and credit of the United States Government. Such securities will include, but not be limited to the following: United States Export — Import Bank -Direct obligations or fully guaranteed certificates of beneficial ownership Farmer Home Administration -Certificates of beneficial ownership Federal Financing Bank -Discount notes, notes and bonds Federal Housing Administration Debentures Government National Mortgage Association (GNMA) -GNMA guaranteed mortgage -backed bonds Investment Policy Page 8 -GNMA guaranteed pass -through obligations General Services Administration United States Maritime Administration Guaranteed -Title XI Financing New Conununities Debentures -United States Government guaranteed debentures United States Public Housing Notes and Bonds -United States Govermnent guaranteed public housing notes and bonds United States Department of Housing and Urban Development -Project notes and local authority bonds 2. Portfolio Composition A maximum of 50% of available funds may be invested in United States Govermnent agencies. 3. Limits on Individual Issuers A maximum of 10% of available funds may be invested in individual United States Government agencies. 4. Maturity Limitations The maximum length to maturity for an investment in any United States Govermnent agency security is five (5) years from the date of purchase. D. Federal Instrumentalities (United States Government sponsored agencies) 1. Purchase Authorization The Finance Director or designee may invest in bonds, debentures, notes or callables issued or guaranteed by United States Government sponsored agencies (Federal Instrumentalities) which are non -full faith and credit agencies limited to the following: Federal Farm Credit Bank (FFCB) Federal Home Loan Bank or its City banks (FHLB) Federal National Mortgage Association (FNMA) Federal Home Loan Mortgage Corporation (Freddie -Macs) including Federal - Home Loan Mortgage Corporation participation certificates 2. Portfolio Composition A maximum of 100% of available funds may be invested in Federal Instrumentalities. 3. Limits on Individual Issuers A maximum of 25% of available funds may be invested in any one issuer. 4. Maturity Limitations City of Miami Investment Policy Page 9 The maximum length to maturity for an investment in any Federal Instrumentality security is five (5) years from the date of purchase. E. Interest Bearing Time Deposit or Saving Accounts 1. Purchase Authorization The Finance Director or designee may invest in non-negotiable interest bearing time certificates of deposit or savings accounts in banks organized under the laws of this state and/or in national banks organized under the laws of the United States and doing business and situated in the State of Florida, provided that any such deposits are secured by the Florida Security for Public Deposits Act, Chapter 280, Florida Statutes. Additionally, the bank shall not be listed with any recognized credit watch information service. 2. Portfolio Composition A maximum of 10% of available funds may be invested in non-negotiable interest bearing time certificates of deposit. 3. Limits on Individual Issuers A maximum of 10% of available funds may be deposited with any one issuer. 4. The maximum maturity on any certificate shall be no greater than one (1) year from the date of purchase. F. Repurchase Agreements 1. Purchase Authorization a. The Finance Director or designee may invest in repurchase agreements composed of only those investments authorized in Section XII.B, C, and D. All repurchase agreements that are legal and authorized by this policy: a Master Repurchase Agreement must be signed with the bank or dealer. All firms are required to sign the City's Master Repurchase Agreement prior to the execution of a repurchase agreement transaction. b. A third party custodian with whom the City has a current custodial agreement shall hold the collateral for all repurchase agreements with a term longer than one (1) business day. A clearly marked receipt that shows evidence of ownership must be supplied to the Finance Director or designee and retained. c. Securities authorized for collateral must have maturities under ten (10) years and with market value for the principal and accrued interest of 102 percent of the value and for the term of the repurchase agreement. Immaterial short-term deviations from 102 percent requirement are permissible only upon the approval of the Finance Director or designee. City of Miami Investment Policy Page 10 d. The overnight sweep arrangement shall adhere to the agreement between the City and the City's depository bank. 2. Portfolio Composition A maximum of 20% of available funds may be invested in repurchase agreements excluding one (1) business day agreements and overnight sweep agreements. 3. Limits on Individual Issuers A maximum of 10% of available funds may be invested with any one institution excluding one (1) business day agreements and overnight sweep agreements. 4. Limits on Maturities The maximum length to maturity of any repurchase agreement is 90 days from the date of purchase. G. Commercial Paper 1. Purchase Authorization The Finance Director or designee may invest in commercial paper of any United States company that is rated, at the time of purchase by two of the three rating agencies, "Prime- 1" by Moody's, "A-1" by Standard & Poor's and F-1 by Fitch (prime commercial paper). If the commercial paper is backed by a letter of credit ("LOC"), the long-term debt of the LOC provider must be rated "A" or better by at least two nationally recognized rating agencies. 2. Portfolio Composition A maximum of 35% of available funds may be directly invested in prime commercial paper. 3. Limits on Individual Issuers A maximum of 10% of available funds may be invested with any one issuer. 4. Maturity Limitations The maximum length to maturity for prime commercial paper shall be 270 days from the date of purchase. H. Corporate Notes 1. Purchase Authorization City of Miami The Finance Director or designee may invest in corporate notes issued by corporations organized and operating within the United States or by depository institutions licensed by Investment Policy Page 11 the United States that have a long term debt rating, at the time or purchase, at a minimum "Aa" by Moody's and a minimum long term debt rating of "AA" by Standard & Poor's. 2. Portfolio Composition A maximum of 25% of available funds may be directly invested in corporate notes. 3. Limits on Individual Issuers A maximum of 10% of available funds may be invested with any one issuer. 4. Maturity Limitations The maximum length to maturity for corporate notes shall be (2) two years from the date of purchase. I. Bankers' Acceptances 1. Purchase Authorization The Finance Director or designee may invest in Bankers' Acceptances issued by a domestic bank or a federally chartered domestic office of a foreign bank, which are eligible for purchase by the Federal Reserve System, at the time or purchase, the short- term paper is rated, at a minimum, "P-1" by Moody's Investors Services and "A-1" Standard & Poor's. 2. Portfolio Composition A maximum of 10% of available funds may be directly invested in Bankers' Acceptances 3. Limits on Individual Issuers A maximum of 5% of available funds may be invested with any one issuer. 4. Maturity Limitations The maximum length to maturity for Bankers' Acceptances shall be 180 days from the date of purchase. J. State and/or Local Government Taxable and/or Tax -Exempt Debt 1. Purchase Authorization The Finance Director or designee may invest in state and/or local government taxable and/or tax-exempt debt, general obligation and/or revenue bonds, rated at least "Aa" by Moody's and "AA" by Standard & Poor's for long-term debt, or rated at least "MIG-2" by Moody's and "SP-2" by Standard & Poor's for short-term debt. 2. Portfolio Composition City of Miami Investment Policy Page 12 A maximum of 25% of available funds may be invested in taxable and tax-exempt General Obligation bonds. A maximum of 10% of available funds may be invested in taxable and tax-exempt Revenue and Excise tax bonds of the various municipalities of the State of Florida, provided none of such securities have been in default within five (5) years prior to the date of purchase. 3. Maturity Limitations A maximum length to maturity for an investment in any state or local government debt security is (2) two years from the date of purchase. K. Registered Investment Companies (Money Market Mutual Funds) 1. Investment Authorization The Finance Director or designee may invest in shares in open-end and no-load money market funds provided such funds are registered under the Federal Investment Company Act of 1940 and operate in accordance with 17 C.F.R. § 270.2a-7, which stipulates that money market funds must have an average weighted maturity of 90 days or less. 2. Portfolio Composition A maximum of 20% of available funds may be invested in money market funds. 3. Limits of Individual Issuers A maximum of 10% of available funds may be invested with any one money market fund. 4. ' Rating Requirements The money market funds shall be rated "AAm" or "AAm-G" or better by Standard & Poor's, or the equivalent by another rating agency. 5. Due Diligence Requirements A thorough review of any money market fund is required prior to investing, and on a continual basis. There shall be a questionnaire developed by the Finance Director or designee that will contain a list of questions that covers the major aspects of any investment pool/fund. L. Intergovernmental Investment Pool 1. Investment Authorization City of Miami Investment Policy Page 13 The Finance Director or designee may invest in intergovernmental investment pools that are authorized pursuant to the Florida Interlocal Cooperation Act, as provided in Section 163.01, Florida Statutes and provided that said funds contain no derivatives. 2. Portfolio Composition A maximum of 25% of available funds may be invested in intergovernmental investment pools. 3. Due Diligence Requirements A thorough review of any investment pool/fund is required prior to investing, and on a continual basis. There shall be a questionnaire developed by the Finance Director or Designee that will contain a list of questions that covers the major aspects of any investment pool/fund. M. Investment of Surplus Funds The City's Investment Policy established and adopted May 10, 2001 pursuant to Resolution N. 01-448, is amended to authorize investment of surplus funds in rated or unrated bonds, notes or instruments backed by the full faith and credit of the government of Israel, and to prohibit investments in any companies with business operations in Sudan or Iran provided that such revisions satisfies specified fiduciary standards. XIII. DERIVATIVES AND REVERSE REPURCHASE AGREEMENTS The City inay invest in investment products that include the use of derivatives as long as the dollar amount invested by the investment product is minuscule to the total dollar amount invested by the investment product. The Finance Director or designee shall develop sufficient understanding of the derivative products and have the expertise to manage them. A "derivative" is defined as a financial instrument the value of which depends on, or is derived from, the value of one or more underlying assets or indices or asset values. If the Finance Director approves the use of reverse repurchase agreements or other forms of leverage, the investment shall be limited to transactions in which the proceeds are intended to provide liquidity and for which the City has sufficient resources and expertise to manage them. XIV. PERFORMANCE MEASUREMENTS In order to assist in the evaluation of the portfolios' performance, the City will use performance benchmarks for short-term and long-term portfolios. The use of benchmarks will allow the City to measure its returns against other investors in the same markets. A. The short-term investment portfolio shall be designed with the annual objective of exceeding the weighted average return (net book value rate of return) of the Florida Local Government Surplus Funds Trust Fund (SBA). B. The long-term investment portfolio shall be designed with the annual objective of exceeding the return of the Merrill Lynch 1-3 Year Treasury Index compared to the portfolio's total rate of return. The Merrill Lynch 1-3 Year Treasury Index represents all U.S. Treasury securities City of Miami Investment Policy Page 14 maturing over one year, but less than three years. This maturity range is an appropriate benchmark based on the objectives of the City. XV. REPORTING A. The Finance Director or designee will prepare quarterly investment reports. Schedules in the quarterly report should include the following: 1. A listing of individual securities held at the end of the reporting period 2. Percentage of available funds represented by each investment type 3. Coupon, discount or earning rate 4. " Average life or duration and final maturity of all investments 5. Par value, and market value B. Annual Investment Report On an annual basis, the Finance Director shall prepare and submit to the City Commission a written report on all invested funds. The annual report shall provide all, but not limited to, the following: a complete list of all invested funds, naive or type of security in which the funds are invested, the amount invested, the maturity date, earned income, the book value, the market value and the yield on each investment. The annual report will show performance on both a book value and total rate of return basis and will compare the results to the above -stated performance benchmarks All investments shall be reported at fair value per GASB standards. Investment reports shall be available to the public. C. Investment Committee The City shall have an investment committee comprised of the Finance Director, Assistant Finance Director, Treasurer, and Investment Coordinator to report to this committee as often as requested. Reports shall be prepared and distributed to the committee quarterly. XVI. THIRD -PARTY CUSTODIAL AGREEMENTS Securities, with the exception of certificates of deposits, shall be held with a third party custodian; and all securities purchased by, and all collateral obtained by; the City should be properly designated as an asset of the City. The securities must be held in an account separate and apart from the assets of the financial institution. A third party custodian is defined as any bank depository chartered by the Federal Government, the State of Florida, or any other state or territory of the United States which has a branch or principal place of business in the State of Florida as defined in Section 658.12, Florida Statutes, or by a national association organized and existing under the laws of the United States which is authorized to accept and execute trusts and which is doing business in the State of Florida. Certificates of deposits will be placed in the provider's safekeeping department for the term of the deposit. City of Miami Investment Policy Page 15 The custodian shall accept transaction instructions only from those persons who have been duly authorized by the Director of Finance and which authorization has been provided, in writing, to the custodian. No withdrawal of securities, in whole or in part, shall be made from safekeeping, shall be permitted unless by such a duly authorized person. The custodian shall provide the Finance Director or designee with safekeeping receipts that provide detail information on the securities held by the custodian. In addition, the custodian shall report at least quarterly and the Finance Director or designee shall verify the reports. Security transactions between a broker/dealer and the custodian involving the purchase or sale of securities by transfer of money or securities must be made on a "delivery vs. payment" basis, if applicable, to ensure that the custodian will have the security or money, as appropriate, in hand at the conclusion of the transaction. Only after receiving written authorization from the Director of Finance shall the City Treasurer be authorized to deliver securities "free". Securities held as collateral shall be held free and clear of any liens. XVII. INVESTMENT POLICY ADOPTION The investment policy shall be adopted by City resolution. The Director of Finance, Treasurer, and the Investment Committee shall review the policy annually and the City Commission shall approve any modification made thereto. PASSED AND ADOPTED BY THE CITY COMMISSION ON JOE CAROLLO, MAYOR ATTEST: WALTER J. FOREMAN CITY CLERK Approved as to form and correctness ALEJANDRO VILARELLO CITY ATTORNEY City of Miami Investment Policy Page 16 Glossary of Terms AGENCIES: Federal agency securities and/or Government -sponsored enterprises. ASKED: The price at which securities are offered. BANKERS' ACCEPTANCE {BA): A draft or bill or exchange accepted by a bank or trust company. The accepting institution guarantees payment of the bill, as well as the issuer. BENCHMARK: A comparative base for measuring the performance or risk tolerance of the investment portfolio. A benchmark should represent a close correlation to the level of risk and the average duration of the portfolio's investments. BID: The price offered by a buyer of securities. (When you are selling securities, you ask for a bid.) See Offer. BROKER: A broker brings buyers and sellers together for a commission. CALL FEATURE or CALLABE SECURITY: A security redeemable by the issuer before the scheduled maturity date. A security is usually called when interest rates fall so that the issuer can save money by floating a new security at lower rates. CERTIFICATE OF DEPOSIT (CD): A time deposit with a specific maturity evidenced by a certificate. Large -denomination CD's are typically negotiable. COLLATERAL: Securities, evidence of deposit, or other property that a borrower pledges to secure repayment of a loan. Also refers to securities pledged by a bank to secure deposits of public monies. COMPREHENSIVE ANNUALFINANCIAL REPORT (CAFR): The official annual report for the City of Miami .It includes five combined statements for each individual fund and account group prepared in conformity with GAAP. It also includes supporting schedules necessary to demonstrate compliance with finance - related legal and contractual provisions, extensive introductory material, and a detailed Statistical Section. COUPON: (a) The annual rate of interest that a bond's issuer promises to pay the bondholder on the bond's face value. (b) A certificate attached to a bond evidencing interest due on a payment date. DEALER: A dealer, as opposed to a broker, acts as a principal in all transactions, buying and selling for his own account. DEBENTURE: A bond secured only by the general credit of the issuer. DELIVERY VERSUS PAYMENT: There are two methods of delivery of securities: delivery versus payment and delivery versus receipt. Delivery versus payment is delivery of securities with an exchange of money for the securities. Delivery versus receipt is delivery of securities with an exchange of a signed receipt for the securities. City of Miami Investment Policy Page 17 DERIVATIVES: (1) Financial instruments whose return profile is linked to, or derived from, the movement of one or more underlying index or security, and may include a leveraging factor, or (2) financial contracts based upon notional amounts whose value is derived from an underlying index or security (interest rates, foreign exchange rates, equities or commodities). DISCOUNT: The difference between the cost price of a security and its maturity when quoted at lower than face value. A security selling below original offering price shortly after sale also is considered to be at a discount. DISCOUNT SECURITIES: Non -interest bearing money market instruments that are issued a discount and redeemed at maturity for full face value, e.g. U.S. Treasury Bills. DIVERSIFICATION: Dividing investment funds among a variety of securities offering independent FEDERAL CREDIT AGENCIES: Agencies of the Federal government set up to supply credit to various classes of institutions and individuals, e.g., S&L's, small-business firms, students, farmers, farm cooperatives, and exporters. FEDERAL DEPOSIT INSURANCE CORPORATION (FDIC): A federal agency that insures bank deposits, currently up to $100,000 per deposit. FEDERAL FUNDS RATE: The rate of interest at which Fed funds are traded. This rate is currently pegged by the Federal Reserve through open -market operations. FEDERAL HOME LOAN BANKS (FHLB): Government sponsored wholesale banks (currently 12 regional banks) that lend funds and provide correspondent banking services to member commercial banks, thrift institutions, credit unions and insurance companies. The mission of the FHLBs is to liquefy the housing related assets of its members who must purchase stock in their district Bank. FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA): FNMA, like GNMA was chartered under the Federal National Mortgage Association Act in 1938. FNMA is a federal corporation working under the auspices of the Department of Housing and Urban Development (HUD). It is the largest single provider of residential mortgage funds in the United States. Fannie Mae, as the corporation is called, is a private stockholder owned corporation. The corporation's purchases include a variety of adjustable mortgages and second loans, in addition to fixed-rate mortgages. FNMA's securities are also highly liquid and are widely accepted. FNMA assumes and guarantees that all security holders will receive timely payment of principal and interest. FEDERAL OPEN MARKET COMMITTEE (FOMC): Consists of seven members of the Federal Reserve Board and five of the twelve Federal Reserve Bank Presidents. The President of the New York Federal Reserve Bank is a permanent member, while the other Presidents serve on a rotating basis. The Committee periodically meets to set Federal Reserve guidelines regarding purchases and sales of Government Securities in the open market as a means of influencing the volume of bank credit and money. FEDERAL RESERVE SYSTEM: The central bank of the United States created by Congress and consisting of a seven member Board of Governors in Washington, D.C., 12 regional banks and about 5, 700 commercial banks that are members of the system. City of Miami Investment Policy Page 18 FLORIDA STATUTES CHAPTER 280: The State Treasurer requires all qualified public depositories to deposit with the Treasurer or another banking institution eligible collateral equal to 50% to 125% of the average daily balance for each month of all public deposits in excess of any applicable deposit insurance held. The percentage of eligible collateral (generally, U.S. governmental and agency securities, state or local government debt, or corporate bonds) to public deposits is dependant upon the depository's financial history and its compliance with Chapter 280, Florida Statutes. In the event of a failure of a qualified public depository, the remaining public depositories would be responsible for covering any resulting losses. GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA or Ginnie Mae): Securities influencing the volume of bank credit guaranteed by GNMA and issued by mortgage bankers, commercial banks, savings and loan associations, and other institutions. Security holder is protected by full faith and credit of the U.S. Government. Ginnie Mae securities are backed by the FHA, V A, or FmHA mortgages. The term "pass throughs" is often used to describe Ginnie Maes. LIQUIDITY: A liquid asset is one that can be converted easily and rapidly into cash without a substantial loss of value. In the money market, a security is said to be liquid if the spread between bid and asked prices is narrow and reasonable size can be done at those quotes. LOCAL GOVERNMENT INVESTMENT POOL (LGIP}: The aggregate of all funds from political subdivisions that are placed in the custody of the State Treasurer for investment and reinvestment. MARKET VALUE: The price at which a security is trading and could presumably be purchased or sold. MASTER REPURCHASE AGREEMENT: A written contract -covering all future transactions between the parties to repurchase -reverse repurchase agreements that establishes each party's rights in the transactions. A master agreement will often specify, among other things, the right of the buyer -lender to liquidate the underlying securities in the event of default by the seller -borrower. MATURITY: The date upon which the principal or stated value of an investment becomes due and payable. MONEY MARKET: The market in which short term debt instruments (bills, commercial paper, bankers' acceptances, etc. are issued and traded. OFFER: The price asked by a seller of securities. OPEN MARKET OPERATIONS: Purchases and sales of government and certain other securities in the open market by the New York Federal Reserve Bank as directed by the FOMC in order to influence the volume of money and credit in the economy. Purchases inject reserves into the bank system and stimulate growth of money and credit; sales have the opposite effect. Open market operations are the Federal Reserve's most important and most flexible monetary policy tool. PORTFOLIO: Collection of securities held by an investor. City of Miami Investment Policy Page 19 PRIMARY DEALER: A group of government securities dealers who submit daily reports of market activity and positions and monthly financial statements to the Federal Reserve Bank of New York and are subject to its informal oversight. Primary dealers include Securities and Exchange Commission (SEC) -registered securities broker -dealers, banks, and a few unregulated firms. PRUDENT PERSON RULE: An investment standard. In some states the law requires that a fiduciary, such as a trustee, may invest money only in a list of securities selected by the custody state -the so-called legal list. In other states the trustee may invest in a security if it is one which would be bought by a prudent person of discretion and intelligence who is seeking a reasonable income and preservation of capital. QUALIFIED PUBLIC DEPOSITORIES: A financial institution which does not claim exemption from the payment of any sales or compensating use or ad valorem taxes under the laws of this state, which has segregated for the benefit of the commission eligible collateral having a value of not less than its maximum liability and which has been approved by the Public Deposit Protection Commission to hold public deposits. RATE OF RETURN: The yield obtainable on a security based on its purchase price or its current market price. This may be the amortized yield to maturity on a bond the current income return. REPURCHASE AGREEMENT (RP OR REPO): A holder of securities sells these securities to an investor with an agreement to repurchase them at a fixed price on a fixed date. The security "buyer" in effect lends the "'seller" money for the period of the agreement, and the terms of the agreement are structured to compensate him for this. Dealers use RP extensively to finance their positions. Exception: When the Fed is said to be doing RP, it is lending money, that is, increasing bank reserves. I I SAFEKEEPING: ! A service to customers rendered by banks for a fee whereby securities and valuables of all types and descriptions are held in the bank's vaults for protection. SECONDARY MARKET: A market made for the purchase and sale of outstanding issues .following the initial distribution. SECURITIES & EXCHANGE COMMISSION: Agency created by Congress to protect investors in securities transactions by administering securities legislation. SEC RULE 15C3-1: See Uniform Net Capital Rule. STRUCTURED NOTES: Notes issued by Government Sponsored Enterprises (FHLB, FNMA, SLMA, etc.) and Corporations that have imbedded options (e.g., call features, step-up coupons, floating rate coupons, derivative -based returns) into their debt structure. Their market performance is impacted by the fluctuation of interest rates, the volatility of the imbedded options and shifts in the shape of the yield curve. TREASURY BILLS: A non -interest bearing discount security issued by the U.S. Treasury to finance the national debt. Most bills are issued to mature in three months, six months, or one year. TREASURY BONDS: City of Miami Investment Policy Page 20 Long-term coupon -bearing U.S. Treasury securities issued as direct obligations of the U.S. Government and having initial maturities of more than 10 years. TREASURY NOTES: Medium -term coupon bearing U.S. Treasury securities issued as direct obligations of the U.S. Government and having initial maturities from two to 10 years. UNIFORM NET CAPITAL RULE: Securities and Exchange Commission requirement that member firms as well as nonmember broker -dealers in securities maintain a maximum ratio of indebtedness to liquid capital of 15 to 1; also called net capital rule and net capital ratio. Indebtedness covers all money owed to a firm, including margin loans and commitments to purchase securities, one reason new public issues are spread among members of underwriting syndicates. Liquid capital includes cash and assets easily converted into cash. YIELD: The rate of annual income return on an investment, expressed as a percentage. (a) INCOME YIELD is obtained by dividing the current dollar income by the current market price for the security. (b) NET YIELD or YIELD TO MATURITY is the current income yield minus any premium above par or plus any discount from par in purchase price, with the adjustment spread over the period from the date of purchase to the date of maturity of the bond. City of Miami Investment Policy Page 21 Exhibit 2 to FINANCE COMMITTEE REPORT ON CITY INVESTMENTS City of Miami Investment Portfolio Total Investments Outstanding As of December 31, 2013 Original Accrued Total Cost Date of CUSIP. Coupon Call Maturity Par Cost of Interest of Interest Market - Market Purchase NUMBER Rate Date Date Value Investment Purchased Investment Receivable Book Value Rate Value Gain/(Loss) U.S. GOVT. AGENCIES 6/28/12 F12 313600NE7 1.150% 6/28/17 860,000.00 860,000.00 - 860,000.00 82.42 860,000.00 99.65500000% 857,033.00 (2,967.00) 11/5/12 SO 3136G03Z2 0.500% 10/30/17 7,000,000.00 7,000,000.00 486.11 7,000,000.00 5,930.56 7,000,000.00 99.50500000% 6,965,350.00 (34,650.00) 11/5/12 SO2 3136G03Z2 0.500% 10/30/17 4,000,000.00 4,000,000.00 277.78 4,000,277.78 3,388.89 4,000,000.00 99.50500000% 3,980,200.00 (19,800.00) 11/5/12 SO2 3136G03Z2 0.500% 10/30/17 7,200,000.00 7,200,000.00 500.00 7,200,500.00 6,100.00 7,200,000.00 99.50500000% 7.164,360.00 (35,640.00) 11/8/12 3135GOQW6 1.000% 11/8/17 3,665,000.00 3,665,000.00 - 3,665,000.00 5,395.69 3,665,000.00 98.23300000% 3,600,239.45 (64,760.55) 11/21/12 3136G04S7 0.750% 2/21/17 10,000,000.00 10,000,000.00 - 10,000,000.00 27,083.33 10,000,000.00 99.43000000% 9,943,000.00 (57,000.00) 11/21/12 SO2 3136G04S7 0.750% 2/21/17 14,200,000.00 14,200,000.00 14,200,000.00 38,458.33 14,200,000.00 99.43000000% 14,119,060.00 (80,940.00) 3/27/13 3136G1GD5 1.100% 3/27/18 10,000,000.00 10,000,000.00 - 10,000,000.00 28,722.22 10,000,000.00 97.71100000% 9,771,100.00 (228,900.00) 3/28/13 3136G1GZ6 1.000% 3/28/18 10,000,000.00 10,000,000.00 - 10,000,000.00 25,833.33 10,000,000.00 97.51900000% 9,751,900.00 (248,100.00) 4/30/13 313601K00 1.010% 4/30/18 10,000,000.00 9,995,000.00 - 9,995,000.00 16,944.44 9,995,669.44 97.48400000% 9,748,400.00 (247,269.44) 5/23/13 F80 3135007(00 1.000% 5/21/18 3,665,000.00 3,665,000.00 203.61 3,665,203.61' 4,072.22 3,665,000.00 97.20700000% 3,562,636.55 (102,363.45) 5/23/13 F81 3135GOXDO 1.000% 5/21/18 1,745,000.00 1,745,000.00 96.94 1,745,096.94 1,938.89 1,745,000.00 97.20700000% 1,696,262.15 (48,737.85) FNMA NOTES 27.84% 82,335,000.00 82,330,000.00 1,564.44 82,331,078.33 163,950.32 82,330,669.44 81,159,541.15 (1,171,128.29) 10/11/12 3133EA4H8 0.820% 7/11/17 4,400,000.00 4,400,000.0P - 4,400,000.00 17,037.78 4,400,000.00 98.65300000% 4,340,732.00 (59,268.00) 10/11/12 F60 3133EA4H8 0.820% 7/11/17 10,000,000.00 10,000,000.00 - 10,000,000.00 38,722.22 10,000,000.00 98.65300000% 9,865,300.00 (134,700.00) 10/11/12 B3 3133EA4H8 0.820% 7/11/17 5,600,000.00 5,600,000.00. - 5,600,000.00 21,684.44 5,600,000.00 98.65300000% 5.524,568.00 (75,432.00) 3/12/13 3133ECHS6 1.030% 3/12/18 10,000,000.00 10,000,000.00 - 10,000,000.00 31,186.11 10,000,000.00 97.40100000% 9,740,100.00 (259,900.00) 3/14/13 3133ECJ39 1.050% 3/14/18 10,000.000.00 10,000,000.00 - 10,000,000.00 31,208.33 10,000,000.00 98.01600000% 9.801,600.00 (198,400.00) 4/25/13 F83 3133ECMM3 0.600% 4/25/17 2,700,000.00 2,700,000.00 - 2,700,000.00 2,970.00 2,700,000.00 98.80700000% 2,667,789.00 (32,211.00) 4/25/13 F85 3133ECMM3 0.600% 4/25/17 2,150,000.00 2,150,000.00 2,150,000.00 2,365.00 2,150,000.00 98.80700000% 2,124,350.50 (25,649.50) 5/8/13 SO2 3133ECNY6 0.950% 5/8/18 13,700,000.00 13,700,000.00 - 13,700,000.00 19,160.97 13,700,000.00 96.74000000% 13,253,380.00 (446,620.00) FEDERAL FARM CREDIT BK NOTES 19.80% 58,550,000.00 58,550,000.00 58,550,000.00 164,334.85 58,550,000.00 57,317,819.50 (1,232,180.50) 1/8/13 3134G32S8 0.750% 6/27/17 5,000,000.00 5.000,000.00 1,145.83 5,001,145.83 416.67 5,000,000.00 98.48100000% 4,924,050.00 (75,950.00) 1/10/13 3134G32Y5 0.920% 12/28/17 10,000.000.00 9.993,000.00 3,000.00 9,996,000.00 750.00 9,991,963.09 97.81400000% 9,781,400.00 (210,563.09) 1/30/13 3134G34K3 1.000% 1/30/18 10,000,000.00 10,000,000.00 - 10,000,000.00 41,944.44 10,000,000.00 97.19400000% 9,719,400.00 (280,600.00) 3/4/13 3134G33B4 1.000% 1/11/18 10,000,000.00 10,000,000.00 14,722.22 10,014,722.22 47,222.22 10,000,000.00 97.86100000% 9,786,100.00 (213,900.00) 3/26/13 3134G36H8 1.000% 3/26/18 10,000,000.00 10,000,000.00 - 10,000,000.00 26,388.89 10,000,000.00 97.22400000% 9,722,400.00 (277,600.00) 4/2/13 313463Z29 1.000% 12/11/17 6,500,000.00 . 6,500,000.00 20,041.67 6,520,041.67 3,611.11 6,500,000.00 97.74900000% 6,353,685.00 (146,315.00) FHLMC NOTES 17.42% 51,500,000.00 51,493,000.00 38,909.72 51,531,909.72 120,333.33 51,491,963.09 50,287,035.00 (1,204,928.09) 9/27/12 313380P27 0.870% 9/27/17 15,000,000.00 15,000,000.00 15,000,000.00 34,075.00 15,000,000.00 98.33500000% 14,750,250.00 (249,750.00) 9/27/12 SO 313380P27 0.870% 9/27/17 5,000,000.00 5,000,000.00 5,000,000.00 11,358.33 5,000,000.00 98.33500000% 4,916,750.00 (83,250.00) 10/24/12 F79 313380WR4 0.850% 7/24/17 4,030,000.00 4,030,000.00 4,030,000.00 14,938.99 4,030,000.00 98.40600000% 3,965,761.80 (64,238.20) 1/8/13 313381PK5 0.770% 6/27/17 5,000,000.00 5,000,000.00 1,176.39 5,001,176.39 427.78 5.000,000.00 98.34900000% 4,917,450.00 (82,550.00) 1/25/13 313381RY3 0.700% 1/25/17 10,000,000.00 10,000,000.00 - 10,000,000.00 30,33333 10,000,000.00 99.44300000% 9,944,300.00 (55,700.00) 2/14/13 3133826J7 0.050% 8/14/17 10,000,000.00 10,000,000.00 - 10,000,000.00 19,027.78 10,000,000.00 98.63700000% 9,863,700.00 (136,300.00) 3/27/13 313382E12 1.000% 12/27/17 15,000,000.00 15,000,000.00 - 15,000,000.00 39,166.67 15,000,000.00 97.82700000% 14,674,050.00 (325,950.00) 3/27/13 313382HE6 1.000% 12/27/17 10,000,000.00 10,000,000.00 - 10,000,000.00 26,111.11 10,000,000.00 98.03400000% 9,803,400.00 (196,600.00) 6/13/13 F12 313381NL5 1.160% 7/10/18 4,800,000.00 4,743,696.00 23,664.00 4,767,360.00 26,448.00 4,749,797.91 97.17000000% 4,664,160.00 (85,637.91) FHLB NOTES 26.66% 78,830,000.00 78,773,696.00 24,840.39 78,798,536.39 201,886.99 78,779,797.91 77,499,821.80 (1,279,976.11) TOTAL U.S. GOVT AGENCIES 91.71% 271,215,000.00 271,146,696.00 65,314.55 271,211,524.44 650,505.49 271,152,430.44 266,264,217.45 (4,888,212.99) COMMERCIAL PAPER 360 DAYS BASIS 12/19/13 MPG 892331-1A69 0.050% 1/16/14 9,700,000.00 9,699,622.78 - 9,699,622.78 - 9,699,797.92 99.99400000% 9,699,418.00 (379.92) 12/19/13 F70 89233HAG9 0.050% 1/16/14 ' 900,000.00 899,965.00 899,965.00 - 899,981.25 99.99400000% 899,946.00 (35.25) 12/20/13 B3 36959JAN3 0.050% 1/22/14 13,900,000.00 13,899,362.92 - 13,899,362.92 - 13,899,594.59 99.99100000% 13,898,749.00 (845.59) TOTAL COMMERCIAL PAPER 8.29% 24,500,000.00 24,498,950.70 24,498,950.70 - 24,499,373.76 24,498,113.00 (1,260.76) GRAND TOTAL U.S. GOVT TREAS, AGENCIES, SBA AND COMMERCIAL PAPER 100.00% 295,715,000.00 B Securities for GOB 2002 Effective 08-02-05, the yield on bond investments can not be greater than the yield restriction of 4.936% 295,645,646.70 65,314.55 295,710,475.14 650,505.49 295,651,804.20 290,762,330.45 (4,889,473.75) B2 Securities for GOB 2007B the yield on bond investments can not be greater than the yield restriction of 4.49 % after 3 years from date of issuance CP ISSUER 5.00% 14,785,750 AGENCY 25.00% 73,928,750 CP 35.00% 103,500,250 Exhibit 3 to FINANCE COMMITTEE REPORT ON CITY INVESTMENTS 5-YEAR CONSTANT TREASURY MATURITY INTEREST RATES 9/28/12-27/13 (weekly) 1- 0.9 0.8 0.7 0.6 0.5. 0.4 0.3 0.20.1 0 -.. Exhibit 4 to ' FINANCE COMMITTEE REPORT ON CITY INVESTMENTS US Department of the Treasury 1/14/14 9:14 PM U.S. DEPARTMENT OF THE TREASURY Resource Center Historical Treasury Rates I Choose a Maturity I YEAR NOMINAL Select to compare Choose Comparison I YEAR NOMINAL • Choose Date Range JAN rii ,.i I To 2014 JAN 4wI I 1.1pda. to Chart Go Key 5 YEAR NOMINAL. 1 YEAR NOMINAL DIFFERENCE. 2,5 , 2011 2012 21l1 2014 Time Period View Text Version of Historical Treasury Rates *This is the difference between the longer maturity rate and the shorter one included in the comparison. If both a nominal and real maturity are selected, then this is the difference between the nominal maturity and the real. http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-LongTerm-Rate-Data-Visualization.aspx Page 1 of 1 Exhibit 5 to FINANCE COMMITTEE REPORT ON CITY INVESTMENTS NO. 216-A (. MARCH 2003 Governmental Accounting Standards Series Statement No. 40 of the Governmental Accounting Standards Board Deposit and Investment Risk Disclosures an amendment of GASB Statement No. 3 rr12111GASBmstt Governmental Accounting Standards Board of the Financial Accounting Foundation 13. Paragraph 41c of Statement 25 is superseded by the following: c. Concentration of credit risk —Identification, by amount and issuer, of investments in any one issuer that represent 5 percent or more of plan net assets. Investments issued or explicitly guaranteed by the U.S. government and investments in mutual funds, external investment pools, and other pooled investments are excluded from this requirement. Interest Rate Risk 14. Governments should disclose information about the interest rate risk of their debt ixiv_e ments by sing_a diselos re me hosLdescribed in paragraph 15 Governments also should disclose the terms of investments with fair values that are highly sensitive to changes in interest rates. ----� 15. Interest rate risk information should be organized by investment type and amount using one of the following methods: a. Segmented time distribution b. Specific identification c. Weighted average maturity d. Duration e. Simulation model. Governments are encouraged to select the disclosure method that is most consistent with the method they use to identify and manage interest rate risk. If a method requires an assumption regarding timing of cash flows (for example, whether an investment is or is not assumed to be called), interest rate changes, or other factors that affect interest rate risk information, that assumption should be disclosed. Governments with investments in mutual funds, external investment pools, or other pooled investments that do not meet the definition of a 2a7-like pool should disclose interest rate risk information according to one of the methods above. 6 57. Some investments' sensitivity to changing interest rates may derive from prepayment options embedded in an investment. An example would be asset -backed securities, which include mortgage -backed or collateralized mortgage obligations. Asset - backed securities are issued by credit providers, such as banks, in which the security represents an interest in the cash flows of a collection of receivables, notes, or mortgages. Prepayments arise when, for example, mortgage holders redeem their mortgages early. The investor's investment is returned early or, in extreme cases (such as interest -only tranches), is not returned at all. Asset -backed securities may be considered to be investments with terms that may cause their fair values to be highly sensitive to interest rate changes. Again, disclosure should be made in consideration of the interest rate disclosure method selected according to paragraph 15. 58. Because of the information that would be disclosed as a result of applying the methods set forth in paragraph 15, the Board also believes that requiring the disclosure of various call features would provide limited useful information. The Board notes that interest rate risk disclosure methods can adequately communicate the effects of call options with the exception of the specific identification method. The Board therefore requires disclosure of call options when this method is used. The segmented time distribution, weighted average maturity, and simulation model methods all require maturity assumptions. Effective duration considers the likelihood that an investment will be called. Once again, the amount of disclosure should be made in light of the interest rate risk disclosure method selected according to paragraph 15. 31 Disclosures Related to Deposits with Financial Institutions, Investments (including Repurchase Agreements), and Reverse Repurchase Agreements 1.56 Concentration of Credit Risk 1.56.1. 0—Should investments in affiliates and subsidiaries of parent corporations be aggregated for deter- mining the concentration of credit risk of an issuer? (Q&A40-31) A —Affiliates and subsidiaries of parent corporations may be engaged in similar activities and may have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions. In these cases, a government should consider the credit risk of the parent company, its affiliates, and its subsidiaries in determining whether a government holds a concentration of credit risk. --- 1.57 Interest Rate Risk 1.57.1. Q—Statement 40 specifies five interest rate risk disclosure methods. May a method be used that is not one of the five? (Q&A40-32) A —No. The GASB's research indicates that the five interest rate risk disclosure methods prescribed in paragraph 15 of Statement 40 are commonly used in practice. The selection among the five methods was permitted to allow a government to choose a disclosure method that is most consistent with the manner in which the government manages its interest rate risk. Because these five methods can adequately communicate a government's interest rate risk exposure, no additional alternatives are permitted. 1.57.2. Q—May different interest rate risk disclosure methods be used in succeeding years? (Q&A40-33) [Amended 2012] A —Yes. Statement No. 62, Codification of Accounting and Financial Reporting Guidance Contained in Pre -November 30, 1989 FASB and AICPA Pronouncements, paragraph 66, indicates that "[a] change in accounting principle results from adoption of a generally accepted accounting principle different from the one used previously for reporting purposes. The term accounting principle includes not only accounting principles and practices but also the methods of applying them" (footnote omitted). Similar to a government using different methods to disclose interest rate risk among its various investment portfolios or funds within the same year, a government may choose to present different interest rate risk disclosures from year to year. To be consistent with its own management practices, a government may need to adopt a different method of reporting interest rate risk in subsequent years to accommodate a change in management, to accommodate a change in portfolio composition, or for other varying reasons. Any government choosing to change interest rate risk disclosure methods also should disclose the nature and reason for the change in accordance with paragraph 75 of Statement 62. 1.57.3. Q—When a debt investment carries a call option, is there a preferable way of disclosing the call option? (Q&A40-34) A —The majority of the interest rate risk disclosure methods outlined in paragraph 15 of Statement 40 can adequately communicate the effects of call options on debt investments. However, governments using the specific identification method of disclosing interest rate risk will need to separately disclose any call options existing on their debt investments. Call options may be identified in the narrative disclosure or may be footnoted to a schedule displaying the government's exposure to interest rate risk. (See Questions 1.60.1, 1.62.1, and 1.63.3. Chapter 1 1.57.4. Q—May one interest rate risk disclosure method be used for short-term investments and another used for long-term investments? (Q&A40-35) A —Yes. Governments may choose among the interest rate risk disclosure alternatives provided in paragraph 15 of Statement 40 so that their disclosure methods are consistent with the way the government identifies and manages interest rate risk. A government may manage its overall interest rate risk by separately identifying the interest rate risk associated with different maturity investments. Investments with interest rates that are fixed for longer periods of time are likely to be subject to more variability in their fair values as a result of future changes in interest rates. To better manage this risk, a government may, for example, choose a more sophisticated method of measuring interest rate risk and may therefore have the information available to disclose that risk using a more complex disclosure model. Allowing a government to report interest rate risk using different methods based on the terms of the investments will enable the government to better align its disclosures with its management practices, T.bt.5 Q=Wihatshioald-b-e-consider-ed 4he-maturity-of a Gnutual bond fund when preparing the interest rate risk disclosure? (Q&A40-36) A —Maturity measures the length of time until a bond issuer is required to pay its investors. Because mutual bond funds invest in many debt issues with different maturity dates, the maturity date of the fund is not fixed. Unlike a 2a7 or a 2a7-like fund, the net asset value for a bond fund changes. Bond funds generally own .many debt investments with differing maturities, so a bond fund reports duration or average maturity —the average of all the debt investment maturities in a fund's portfolio, weighted by the par value of each investment. For example, a mutual bond fund with a weighted average maturity of 8.5 months could be reported using the segmented time distribution as an investment with a maturity of less than one year. 1.57.6. Q—A mutual bond fund or external investment pool has demand features, permitting participants to withdraw their positions with short notice. Does this feature cause the investment's maturity to be very short-term, such as under the segmented time distribution method to be presented as having a maturity of less than one year? (Q&A40-37) [Amended 2005] A —No. Consideration should be given to the distinction between a mutual bond fund's or external investment pool's maturity and the flow of deposits and withdrawals. Governments may add moneys to mutual bond funds or external investment pools or withdraw moneys based on cash flow needs rather than when the investments mature. As stated in Question 1.57.5, a bond fund (and by extension an external investment pool) may report average maturity weighted by the par value of each bond. It is the focus on the bond fund's or external investment pool's maturity that should be considered when designating the investment into the appropriate time distribution for interest rate risk disclosure. Disclosures Related to Deposits with Financial Institutions, Investments (including Repurchase Agreements), and Reverse Repurchase Agreements 1.57.7. Q—A government holds a variable -rate investment with a coupon that resets every three months. How does the reset impact the government's interest rate risk disclosure? (Q&A40-38) A —Statement 40 defines interest rate risk as "the risk that changes in interest rates will adversely affect the fair value of an investment." The fair value of repricing securities (debt investments with a coupon that resets on a specific date or frequency) is generally less susceptible to fluctuations in value because the variable -rate coupon resets back to the market rate on a periodic basis. Interest rate risk disclosure methods that consider investment time horizons and maturities (weighted average maturity, segmented time distribution, and duration) generally make assumptions regarding the maturity of the investment for interest rate risk purposes. Effectively at each reset date, a debt investment with a variable -rate coupon reprices back to par value, thus eliminating the interest rate risk on the investment at each periodic reset. Similar to the actual maturity of the investment, the debt investment's price will not fluctuate when the coupon rate is equal to the market rate of interest, and consequently many governments may assume that the maturity for interest rate risk purposes is the length of time until the next reset date `rather than the stated maturity. In accordance with paragraph 15 of Statement 40, governments should disclose any maturity assumptions that affect interest rate risk information. However, governments holding investments with variable -rate coupons should consider the effects of caps, floors, and collars (a combination of caps and floors) in the determination of the investments' maturities. For example, a government holds a variable -rate investment having a three-month coupon reset with a cap of 4 percent. If interest rates at the time of the reset were 5 percent, the cap would prevent the investment from repricing to par, causing the fair value of the investment to remain below par and take on the characteristics of a fixed-rate bond, should interest rates remain over the cap of 4 percent. Both the repricing of the debt investment's coupon to the market rate and the shorter assumed maturity of the instrument tend to lower the magnitude of the interest rate risk associated with the debt investment. However, as previously noted, variable -rate investments with coupon resets may also be coupled with a cap, a floor, or a collar. Such features may prevent reset to par at each reset date, affecting both the maturity and the fair value of the investment. A government should analyze the effects of these features on the fair value of its investments when determining interest rate risk. 1.57.8. Q—Should the financial statements of a governmental 2a7-like pool disclose the interest rate risk of its debt investments? (Q&A2009-1.57.8) A —Yes. The interest rate risk disclosures required by paragraphs 14-16 of Statement 40, as amended, apply to all government organizations, including 2a7-like pools. 1.58 Disclosure Methods 1.59 Segmented Time Distribution 1.60 Specific Identification 1.60.1. Q—Under the specific identification method, how would a government illustrate a debt investment with a variable coupon that resets each quarter? (Q&A40-39) A —The specific identification method requires a government to list its investments and the investments' respective maturities. For interest rate risk purposes, the government may consider a variable -rate debt investment with a quarterly reset to have a maturity equal to the length of time until its next reset date. 1-46 Chapter 1 In addition to the identification of the investment, the government should disclose, either as a narrative or as a footnote to the schedule, the maturity assumption related to the investment's coupon reset and the terms of the Investment in accordance with the provisions of paragraph 16 of Statement 40, as amended. >1.61 Weighted Average Maturity 1.61.1. Q—Under the weighted average maturity method of disclosing interest rate risk, what are the cash flows assumptions that are used in the calculation? Do they include such items as principal payments occurring on a periodic basis prior to maturity, interest payments, or the effects of callable bonds? (Q&A40-40) A —The weighted average maturity method expresses investment time horizons —the time when investments become due and payable —in years or months, weighted to reflect the dollar size of individual investments within an investment type. The cash flows assumptions associated with the weighted average maturity method focus on the maturity value of the instrument, taking into consider- ation principal payments occurring on a periodic basis prior to maturity. The weighted average maturity et -hod -also s overnments to make assumptions as to the effective maturit of callable investments, which should be disclosed. (See Question 1 57 t3 ) 1.62 Duration 1.62.1. Q—Does Statement 40 specify which method of duration should be applied? (Q&A40-41) [Amended 2006] A —No. There are three common types of duration used to report interest rate risk —Macaulay duration, modified duration, and effective duration. Duration methods can be calculated using analytical software. Macaulay duration is a measurement of the weighted average term to maturity of a bond's cash flows whereby the weighting is based on the present value of each cash flow divided by the price. Modified duration is a measure of the price sensitivity of a bond to interest rate movements. It is equal to the Macaulay duration divided by (1 + [bond yield / k]) where k is the number of compounding periods per year. Effective duration is a method of disclosing interest rate risk that measures the expected change in value of a fixed -income security or portfolio for a given change in interest rates. Because effective duration makes assumptions regarding the most likely timing and amounts of variable cash flows, it is particularly useful for measuring interest rate risk of callable bonds, collateralized mortgage obligations, and other mortgage -backed securities. Both modified duration and effective duration provide a measure of risk that changes proportionately with market rates. For example, if interest rates fell by 1 percent, the value of a security or portfolio having a modified or effective duration of 3.0 generally would increase in price by 3 percent. Duration methods can be calculated using analytical software. Duration, as a measurement of the impact of interest rates on bond prices, is only an approximation. Effective duration tends 'to be a more accurate measure of interest rate risk when there are large changes in prevailing interest rates, unlike both Macaulay and modified duration whose error magnifies as the changes in prevailing rates get larger. Whereas effective duration makes assumptions regarding the most likely timing and amounts of variable cash flows, Macaulay and modified duration do not take into account such variable cash 1-47