HomeMy WebLinkAbout2008-09-17 e-packetASH S
o ° ~~~~~~~'~~ SPECIAL MEETING
~.
o
cgLIFOR~l~ CITY COUNCIL
OF THE
CITY OF SOUTH SAN FRANCISCO
P.O. Box 711 (City Hall, 400 Grand Avenue)
South San Francisco, California 94083
CITY HALL
LARGE CONFERENCE ROOM
400 GRAND AVENUE
WEDNESDAY, SEPTEMBER 17, 2008
6:30 P.M.
NO 1 ICE IS HEREBY GIVEN, pursuant to Section 54956 of the Government Code of the
State of California, the City Council of the City of South San Francisco will hold a Special Meeting on
Wednesday, the 17th day of September, 2008, at 6:30 p.m., in the Large Conference Room, at City
Hall, X100 Grand Avenue, South San Francisco, California.
Purpose of the meeting:
1. Call to Order.
2. Roll Call.
3. Discussion with Elections Manager David Tom of the Office of the
Honorable Chief Elections Officer, County Assessor- Clerk- Recorder.
4. Outside Investment Review.
5. Closed Session: Conference with Real Property Negotiator
(Pursuant to Government Code Section 54956.8)
Property: APN Nos. 015-010-260, 015-010-270, 015-010-600, 015-190-
170 and 015-190-190 (Oyster Point Marina area parcels)
Negotiating Parties: City of South San Francisco and Oyster Point
Ventures, LLC;
Under Negotiation: Purchase and lease terms and price.
6. Adjournment.
~~~
Iman Mouasher
Deputy City Clerk
5°~~x"5-~~'
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J O
c'~LIFOR~~~ t ~ e o rt AGENDA ITEM # 4
DATE: September 17, 2008
TO: Honorable Mayor and City Council
FROM: Richard Battaglia, City Treasurer
Jim Steele, Director of Finance
SUBJECT: STUDY SESSION ON' CITY INVESTMENTS
RECOMMENDATION:
Staff and the City Treasurer recommend the City Council review the attached materials,
including a report from MBIA, an outside financial consulting firm, and discuss options at
the Study Session for implementing the reports recommendations.
BACKGROUND/DISCUSSION:
During meetings with the Finance ;Subcommittee of the City Council in 2007, it was agreed that
an outside review of the City's portfolio by a qualified financial advisor with California
municipality experience would be: an important oversight item to provide the City Council
outside assurance that City investment risks were minimized.
In April 2008, the City Council aI>proved a budget amendment to authorize the expenditure of
funds for a review of the City's investment policy and portfolio. When staff brought the budget
amendment to Council, it was stated that the purpose of this review would be to ensure the
portfolio is safe and following appropriate municipal investment strategies for a city like South
San Francisco with part time investment staff. Because the State of California has a very
restrictive set of criteria for municipalities to invest in, staff believed it was critical to have an
investment oversight firm with municipal expertise and familiarity with the relevant State
Government Code provisions to p~°rform the review. City staff selected MBIA to perform the
review, and they have now completed their report. Some of their recommendations will require
additional resources to implement, and the need for those resources should be weighed against
the relative risk of the City's investment program.
Staff Report
Subject: Study Session on the City's Portfolio and Investment Policy
Page 2 of 2
FISCAL IMPACT:
The $4,000 cost for this review has already been funded. Additional resources to implement
recommendations could be needed, depending on the level of additional investment services the
City Council determines are needed.
CONCLUSION:
A periodic review of the City's investment policy and practices and portfolio holdings is a
prudent course to take to ensure that the public's funds are adequately safeguarded. The City
Council may wish to focus its discussion and questions on the relative risks inherent in the City's
investment program, and determinE; if additional resources should be utilized to either improve
safety, oversight, or reporting, or to increase the yield of the portfolio over time.
Prepared by: `~ ~./` ~~~ ~.-~'~~~ ~` I ~ Approved by. '' •~
Ric and Battaglia r~ Barry .Nagel ~
Cit ;Treasurer City Manager
Prepared by: ~~ ~~ ~
Jirr%Steele
Finance Director
Attachments: Power Point outline 1~rom staff
MBIA Report
City of South San Francisco
Portfolio and Investment. Policy
Review
September 17, 2008
Scope of Work Contained Three Basic
Tasks......
• Review the City's investment policy and provide
feedback to the City Council on the relative safety of
the policy. Make any recommendations on changes
appropriate for a City our size.
Three General Areas Were Askedl of the
Consultant......
• Review the City's holdings and provide feedback on
the relative safety of the portfolio.
Three General Areas Were Asked of the
Consultant......
• Given the limited resources at the City's disposal, does
the consultant have any recommendations for changing
investment strategy or portfolio composition that might
increase the City's yield over time?
Safety and Liquidity Come First
• Increasing yield is considered the third priority in a municipal
portfolio, after safety and liquidity, to preserve the public's
principal and have it available to pay bills as they come due.
• The investment by a former Treasurer in several medium
term corporate notes placed yield first, over safety and
liquidity.
No Medium Term Corporate Notes have
been Purchased since....
The Treasurer has been working w/the Finance
Department to report regularly to the Council on the
City's holdings.
2
The City's Portfolio is essentially in
"Plain Vanilla" holdings
Other than the City's holdings in the State and
County Pool, and other than its bank account with
First National Bank which is used to pay bills, the
only investments held are AAA rated securities
issued by U.S. Government enterprises.
None of the City's investments are mortgage
backed securities.
Conservative, Buy and Hold Practice
Like most other municipalities our size in California,
the City practices "buy and hold", buying highly
rated US Agency securities and holding them until
maturity. This is also known as a "passive" strategy.
Buy and Hold Practice
Since the City only buys AAA US
Government Agency securities, ratings are
not likely to change.
The recent activities by the government to
prop up Fannie Mae and Freddie Mac affirm
the AAA ratings of those agencies.
Major recommendations;
Other than clarifying several aspects of
the portfolio policy, MBIA makes 4 major
recommendations.
1. Limit Exposure to the San Nlateo
County Pool
The Treasurer and staff agree, and have
been reducing our holdings here over time,
and the holdings are now down to le;>s
than 5% of the portfolio.
2. Limit exposure to First National Bank
The Treasurer and staff agree, and the
City has opened a highly liquid, AAA
rated money market mutual fund
administered by the California Asset
Management Program (CAMP), which it
wilt use to "park" funds for short periods
of time until bills are paid. CAMP is a joint
powers authority overseen by public
seclor Treasurers and Finance Directors.
4
3. Further clarify or restrict the
investment policy in ways that ;are
consistent with a buy and hold practice
There are several recommendations,
which staff and the Treasurer agree Nrith.
4. Consider Several options for adding
resources to the investment function
In order to increase yield, the City could
consider one of several strategies to add
resources to the investment function.
After reviewing MBIA's report, the Council
may want to focus questions and
discussion on the relative risk of the
current investment program, and the
relative reward from adding resources.
MBIA Presentation
INVESTMENT MANAGEMENT PROGRAM REVIEW
PREPARED FOP. THE
~.+ITY OF SOUTH SAN FRANCISCO
EXECUTIVE SUMMARY
Public agencies, including municipalities, are limited when it comes to investing. California guidelines
for investing public funds are set forth in Governmenf Code Secfion 53609. The priorities dictating
how these funds are invested are safety, liquidity and yield. Safety is the primary concern for all public
agencies as the funds they invest cannot be replaced should losses occur due to poor investment
decisions. The City of South San Francisco (the City) is acutely aware of this fact because they
experienced just such a loss when a previous treasurer lost City funds through an investment in a
WorldCom medium-term note. The second highest priority is adequate liquidity. Public funds must be
invested such that they are available to meet all upcoming obligations of the agency. The third priority
is yield, but only after the first two are adequately addressed.
MBIA Asset Management was asked to evaluate the City's investment program. The scope of work
included the following:
1. Review the City's investment policy and provide feedback to the City Council on the relative
safety of the policy. Make any recommendations on changes appropriate for a City of our size.
2. Review the City's holdings and provide feedback on the relative safety of the portfolio.
3. Given the limited resources at the City's disposal, does the consultant have any
recommendations for changing investment strategy or portfolio composition that might increase
the City's yield over time?
A detailed report of our evaluation is attached. In summary, MSfA Asset Management f nds the
following:
1. The City's investment policy rE:flects the allowable investments of the California Government
Code. Given the City's limitecl oversight resources, some of these allowable security types
(bankers acceptances, medium-term corporate notes, repurchase agreements), while not held in
the City's portfolio, should be further restricted in the policy, if not excluded altogether. The
review includes a number of additional recommendations that further clarify and update the
investment policy language. These recommendations reflect the City's need for safety and the
limited resources currently available to the finance staff.
2. The City's investment holdings are generally safe and conservative, and are consistent for a
portfolio for which only limited resources are available for day to day portfolio management. The
City employs a passive "buy and hold" investment style, which is not unusual for a city of this
size and limited resources. Our review of the City's investment program revealed two areas of
concern with regard to the safely of its liquid investments. They are as follows:
A review of the San Mateo County Pool reveals that thirty percent of the portfolio is
invested in securities which are rated AA- or lower by Standard & Poor's. One percent of
the portfolio is invested in securities rated A- or lower. While the Treasurer has been
reducing the City's exposure to the county pool we believe that the City should limit this
exposure to no more thar~ 5 percent of its total portfolio. We do not however, recommend
immediate withdrawal of all funds from the pool as this may cause the City to incur
withdrawal penalties.
~~~~ CIT1' OF 50UTH SAN FRP.NCISCO
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b. First National Bank of ~iorthern California's loan portfolio has been demonstrating a
significant deterioration in ~auality. Deposits at the bank are only insured by Federal Deposit
Insurance Corporation (FDIC) up to $100,000. We recommend that the City reduce its
exposure to First National Bank and transfer funds into a AAAm rated money market
mutual fund. Such a fund will provide the City both safety and liquidity.
The bulk of the remaining core portfolio is invested in U.S. Instrumentality securities issued by
government sponsored enterprises (GSEs). Many news stories regarding the rise in mortgage
defaults have questioned the underlying backing of both Fannie Mae and Freddie Mac.
Recently, the Department of the Treasury and the Federal Housing Finance Agency have taken
over ailing mortgage finance companies Fannie Mae and Freddie Mac due to an increase in the
number of mortgage defaults. The New York Stock Exchange announced that it suspended
trading in Fannie and Freddie stock shares following the government takeover. Under the terms
of the agreement, both companies will be under government control indefinitely, the chief
executives of both companies will be removed and the government will invest X100 billion in
each company to make sure ghat they maintain a positive net worth. Given this takeover and
the injection of needed capital, bonds issues by these companies can now be considered to
have the direct backing of they federal government. We recommend that the City diversify its
holdings of GSEs and limit exposure to any one GSE to no more than 25 percent of the
portfolio. We also recommend that the City consider further diversification of its portfolio
through the use of U.S. Treasury securities.
In conclusion, we would like to state that the City's investment program is fundamentally sound and
we applaud the City's conservative approach to investment management. Through extensive
discussions with the City's finance staff and the City Treasurer we have come to understand that only
limited resources are allocated to thE~ investment function. This has forced the Treasurer and staff to
focus mostly on the safety and liquidity of the funds. improved investment performance will most likely
require additional resources. There are two options to consider:
1. Add additional experienced investment staff to augment the current resources - A dedicated
investment officer could monitor the markets on a daily basis gathering additional information on
which strategies will most likely lead to enhanced returns given current and future economic
conditions. This person would require additional resources, such as a Bloomberg system, to
improve market access and provide analytical tools to allow them to evaluate the information
gathered.
2. Consider the use of a professional investment manager - In this instance, the City would divide
the portfolio into liquid and core portfolios. The Treasurer would manage the liquid portfolio to
ensure that the City's short-tern obligations are met. The longer-term core portfolio would be
managed by an outside investment manager who specializes in the management of public
sector portfolios. It must be noted that only a few investment advisors have the expertise and
proven track record to manage portfolios in compliance with the California Government Code.
The advisor must also demonstirate a proven track record to show that their performance is more
than sufficient to cover the cost of their management fee. This may well be a cost effective way
to obtain additional performance without the permanent cost of added staff. Professional
investment management can be provided through anon-discretionary agreement. Under such
an agreement, the Treasurer must authorize all trades recommended, thus maintaining fiduciary
control over the portfolio. In this: instance, the investment manager would serve as an extension
of City staff providing research, expertise, buying power and efficiencies that a small city cannot
reasonably afford on its own.
While the full body of our report presents all of our recommendations, we realize that resources are
finite and that all of the recommendations cannot be implemented without adding more staff. Our
discussions with the City's staff indicate they believe that segmenting the portfolio and securing an
external investment manager is the preferred option that they would like to pursue at an upcoming
Council study session.
6~
CITY Or SOUTH SAN =RANCISCO
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INVESTMENT MANAGEMENT PROGRAM REVIEW
PREPARED FOR THE
CITY OF SOUTH SAN FRANCISCO
Scope of f~eview
MBIA Asset Management (MBIA) has completed a review of the City of South San Francisco's (the
City's) investment management program and the current composition of the City's portfolio.
Information was gathered through an on-site interview conducted with the City's finance/accounting
staff and the City's Treasurer. In addition, MBIA reviewed the City's Investment Policy and Portfolio
Management reports, including Portfolio Summary and Portfolio Details -Investments and Cash.
MBIA`s recommendations are presented in the following areas:
• Oversight and Strategy Setting
^ Investment Policy and Procedures
• Portfolio Management
• Investment Performance
• Investment Accounting and Reporting
We commend the City's efforts to proactively review the investment program. The City manages a
significant amount of funds, and investment earnings are an important consideration of any program,
after safety of principal and liquidity of funds. The following recommendations are intended to
strengthen the City's program in fight of these objectives and constraints. Not all of these
recommendations may be practical, given the limited resources presently available to the City
Treasurer and finance staff.
Oversight anti Strategy Setting
OVERSIGHT
Currently, strategy setting is conducted by the City's Treasurer, an elected official, in consultation with
the Finance Director. On a quarterly basis the Finance staff provides a list of new investments and a
list of called and matured investments, as well as a graph showing the asset allocation and the
allocation along the yield cun~e. This report is relatively comprehensive ar~d provides most of the
relevant information required to make informed judgments about the past portfolio strategy and
current portfolio holdings. Quarterly oversight is provided by the investment committee and City
Council. Additional information could be provided to aid in the oversight of the portfolio such as a
report that complies with GASB statement f~Jo. 40, information on each transaction including the
names of the brokers and the prices that they gave, and additional performance information. We will
cover these additional topics in greal:er detail under the investment Accounting and Reporting section.
RECOMMENDED CHANGES
We recommend that the frequency of these reports be increased to monthly to provide the Investment
Committee more timely information about the current holdings and changes in the investment
strategy, especially given current rnarket conditions. if at ail practical, the Investment Committee
should meet monthly to review the reports and continue providing the City Council with quarterly
updates as required by California state code. 1Ne acknowledge that monthly reporting and reviews
may require additional staff resources.
~~~ CITY OF SOUTH 5AN FRANCISCO
-~-
The reports provided should place a greater focus on the current investment strategy of the portfolio
and should include a commentary on how the current strategy takes advantage of the existing rate
structure and the current economic environment. In addition, the report should place more emphasis
on portfolio performance and include: a comparison of the current and past performance between the
City's portfolio and the portfolio's benchmark. See additional recommendations under reporting.
SETTING STRATEGY
Even with improved oversight from the Investment Committee and City Council, it will still be
necessary for the daily portfolio strategy to be implemented by City staff. Regular meetings should be
held within the department to set claily strategy and to review recent purchases. A formal review
process for each trade should be irriplemented so that a reasonable oversight of all portfolio activity
occurs in a consistent and timely manner.
DRIVERS OF PORTFOLIO PERFORMANCE
As the graph below shows, there are three main drivers of performance for short-term high quality
fixed income portfolios: duration management, sector selection, and security selection. These drivers
of performance should be used as a guide for setting portfolio strategy. Duration management
involves adjusting the portfolio's duration to take advantage of current and anticipated future interest
rates. Sector selection is the allocation of portfolio assets across different fixed income market
sectors (Treasury, government, and high grade corporate securities) to take advantage of the
changing spreads between these sectors. Security selection combines both the credit analysis of
individual securities and the structure of the security, which takes into account any option embedded
in the security. As the graph shows, duration management plays the largest role in portfolio
performance.
Primary Drivers of Portfolio Performance
Selection
Effect, -~ _ _ __
za% , .--
F
DURATION MANAGEMENT
A portfolio's target duration should k>e adjusted based on current market conditions. We favor alow-
risk asymmetrical range to limit the portfolios market risk. An asymmetrical range means that the
portfolio maturity is only extended 10 percent above the target, but may be shortened by as much as
50 percent to avoid market risk. A simple strategy is to extend the weighted average maturity of the
portfolio when the Treasury note representing the target duration has a yield which is higher than its
long-term average. The average maturity of the portfolio is allowed to shorten when the yield on the
target Treasury falls below its long-term average. The graph below illustrates this strategy. These
broad market indicators must also be combined with general market and economic conditions to
formulate a final strategy.
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~~ CITY OF SOUTH SAN FRANCISCO
-g-
BGr111J Yi Bi°
Yield 2.025
High on DBr23108 5.270 ~!y ~ ~ 5.000
A.rerage 3.418 ~~5
Low on 0811 DrD3 1.088
r
lE ~~ 4.000
w ~~
,,..K,.~..., _~„-„-..,: ..~,>..,,,..~... ,..W.:„...~...s„-, ~~~~..,..»~:....~..,.-,..,...f..,.,.<-~-..r.v.,W-.:+ r.a,:,r.«:.,.,.~,~.e.~..,,~,m-_:~..~.n: ~amu ,,,»o..-... ..>,~,„, 7.DU0
e 1 t
a k%~ ~ 2.OUD
2-Year 6-Year Average
Treasury Yield Yield t.DDD
i 2UD3 ~ 2004 I 2005 I 2008 I 2007 12008 I
Extending the portfolios duration provides the portfolio with both risk and reward. The graph below
illustrates the return benefits of moving the portfolio's duration longer. This graph also illustrates that
over an extended period of time portfolio performance may be negative in some quarters.
Total Return Performance vs LAIF
July 1, 1998 to June 30, 2008
7.00 % ;
6.00 % T
5.00 % ~
a.oo% 3.64%
a.: - -
3.00 % +
2.00 % ~.
1.00
t
0.00 / -- . ..,....
3-month Treasury
Bill
zo
18
5.73%
16
5.01
4.68% 1a
89%
3 4.17°0
.'
12
.
.71 % ~
~° - io
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,......~..»~. ..,.,..-.. -
--+- --I
-- ---i
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LAIF 6-month Treasury 1-Year Treasury 1-3 Year Treasury 1-5 Year Treasury 3-5 Year Treasury
Bill Index Index Index
ate Return --~~ Number of Negative Quarters
SECURITY SELECTION
Some market conditions favor callable securities while others favor non-callable securities. These
same market indicators can be used to help the portfolio manager alter his security selection strategy.
The graph below shows when to bt.ly callable securities and when to avoid them.
Lmbia
CITY OF SOUTH SAN FRANCISCO
-10-
BG N!N Y16id ~
Y"field ?.0.5 ~ ~
High on DB~'L3.~178 5.'s7U ryf ~ ~yty 5.UD0
L>w o ~ UBi t's,n, 1.DSe
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~~~ ~~~~ 4.000
A~1 ~f ~ - 3.000
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~'~ ~~ ~ '~ 2-Year
'~> Treasury Yield 6-Year Average
Yield 7.UD0
M G. M i J A 5 0 tJ G i F t,~ :~ IrA i~ 0.a 0 N D i F M A M J k 5 O tJ U I F M A M S O tJ U F tit H M J R S O tJ D F 1~1
2003 2004 2005 2008 2007 zooa
SECTOR MANAGEMENT
The spreads between different markE:t sectors change constantly and they are often driven by varying
credit conditions. The chart below illustrates how the spread between the 2-year Treasury and the 2-
year agency changed during 2007. A simple strategy is to buy Treasury securities when the spread
between Treasury and agency securities drops below the long-term average, and to buy agency
securities when the spread is at or at~ove the long-term average. As shown in the example below, the
long-term average of this spread relationship is approximately 25 basis points. The same kind of
spread analysis can be used to establish a strategy for corporate securities. When the spread on
corporate securities relative to agency securities widens above their historic average, the corporate
securities become a relatively better value. Furthermore, this same strategy can be used between
corporate securities with different rates. However, tracking the relationships between historical
spreads is based on having access to market information.
_~cll F • [•ll~, F:}~.~• ~dl~ ~P.a~geyr1l~22-7 `ilcl:l `~Iil~cCt:
C'i:1Ti e -• • ~ r~~TCt ~~ F F - F F. I I • I
scii~oTm c,~.,i zsio Hl:ss tz SPREHD SUMMAPI`
2.T3~1 M
~~ Last 71.3063
Mean 2?.?011
~ Uff Avg 43.6031
Median 25.3594
i ~~ ,~ StGev 10,6427
2T1 off Avg StDev 4.1G
Percentile 49.62
~~'x ~ Hioh (02;'22J08 71.3063
Low (06J27/G3j ?.8175
F11.' ~ OCCUF:REIJC:S
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star 2H _ep ~c3dar'LBin~.`cp 3a>ec 31.. Jun 'LBeF9.fc;i't ar.'JLri r-p lY,EC 2-7ai'.'lLn 2S~G ~ ar 2ti~r.
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•
~~ CITY OF SOIJTH 5AN FP.ANCISCO
_1~_
Investment ~oliey aryd f~racedures
The City of South San Francisco's adopted Investment Policy is dated June 13, 2007. The investment
policy is an important document because it defines goals and establishes guidelines for investing
funds. The City's investment policy should be viewed as the master plan for defining the rules of the
investment program. Investment procedures put the policy into action while internal controls ensure
the policy and procedures are followed.
Overall, the City's investment policy is quite flexible and allows for a wide range of latitude in many
areas. MBIA recommends that the City tighten the language in the policy in order to improve controls
in the City's investment program. The: investment policy should clearly define the City's objectives and
constraints for investing. It will be an especially important document given potential changes in
Finance personnel and the part-time nature of the Treasurer's position.
The City's policy was reviewed relative to California Government Code and to sample investment
policies provided by the Government Finance Officers Association and the Association of Public
Treasurers. In addition to complying with state statute guidelines, the City's policy generally
addresses all items recommended by these two organizations.
T he recommendations that follow are: intended to further refine and strengthen the City's policy. Many
of the recommendations involve adding detail so the information in the policy becomes more
meaningful to the reader, and most of the recommendations relate to the securities authorzed for
purchase. In general, MBIA recomn-rends that the City more clearly define eligible investments and
any relevant restrictions. Specific comments regarding particular sections of the City's policy are
presented below.
INTRODUCTION
The introduction adequately describr:s the guidelines under which the City's funds shall be invested.
The well known principles for safety, liquidity, and yield are the cornerstone of public investing. The
safety seoti:.r~ mentions .h~ :.^fo pri;;~ary ~aUSes ~f risk to a public portfolio, ~r/ hich are interest rate risk
and credit risk. The liquidity section sets the limit on maturities at five years, which is consistent with
other government entities in the state of California. It also requires the portfolio to keep sufficient
liquidity "to meet all reasonably anticipated operating expenses." This language seems somewhat
vague, which may foster a tendency to keep too much of the portfolio liquid. The section on yield
defines the benchmark as the three month Treasury bill, which may not be a reasonable benchmark
for the portfolio. It is also silent on a target weighted average maturity for the portfolio, which could be
a helpful guide to the Treasurer.
RECOMMENDED CHANGES
We recommend changing the liquidity section to mirror the six months of adequate liquidity required
by state code. The benchmark should be changed to better match the existing portfolio and a more
detailed benchmark recommendation is described under the reporting section, on page 10.
We further recommend that the portfolio select a target weighted average maturity of approximately
1.5 years. This maturity range has what we consider the most attractive risk/return profile. As shown
by the graph in the duration management section this maturity range has outperformed LAIF by 97
basis points over an extended period of time, while experiencing only three quarters of negative
performance during the period.
Finally, persons or positions authorized to conduct investment transactions on behalf of the City
should be fisted as an appendix to the policy to clearly define these persons for the reader.
€~~
CITY OF SOUTH SAN FRANCISCO
_1?_
AUTHORIZED INVESTMENTS
We suggest this section be reworked to include a more meaningful description of each authorized
investment including maximum maturity, credit limitations, and diversification requirements per issuer.
The City should add language with rE~spect to repurchase agreements in the policy including counter-
party credit criteria, acceptable collateral, collateral delivery requirements, and minimum margin
levels. Examples of suggested revisions follow.
U.S. TREASURY SECURITIES
This section of the policy should stars: with authorizing the use of U.S. Treasury Securities. Language
should authorize the purchase of Treasury bill, notes, and bonds with maturities not to exceed five
years. Treasury securities should be considered the foundation of a good public sector portfolio. They
provide safety for the portfolio and capture a substantial portion of the additional return over LAIF
while not exposing the portfolio to credit risk. Treasuries are used when spreads fall below the
average.
U.S. INSTRUMENTALITY SECURITIES
The policy should authorize the purchase of instrumentality securities next. Descriptions of the
authorized issuers and the security structures that have been approved for instrumentality issuers
should be included. For example, this section could authorize debentures, discount notes, callable
securities, step-up bonds, and floating rates securities for instrumentality issuers. The maximum
maturity for these securities is five years per state statute. The City should limit instrumentality issuers
to those that have the most active secondary markets, including Federal National Mortgage
Association (FNMA), Federal HomE: Loan Mortgage Corporation (FHLMC), Federal Home Loan
Banks (FHLB), and Federal Farm Credit Bank (FFCB).
U.S. Treasury and instrumentality securities and repurchase agreements backed by these securities
have the highest credit quality and the greatest liquidity. As such, MBIA recommends that the City not
limit its holdings to these types of securities, though the City may want to restrict the portfolio per
instrumentality issuer. For example, guidelines could state that no more that 20 percent of the
portfolio may be invested in any one iinstrumentality issuer (i.e., FNMA, FHLMC, FHLB, or FFCB).
Note: The securities listed above do not include mortgage-backed securities (MBS) issued by the
instrumentalities. It is our belief that these securities ~rP generally not a~prppriate for public portfolios.
Their extended maturities and prepayment of principal carry considerable risk that most public entities
are not equipped to evaluate. The section on instrumentalities should specifically prohibit the use of
MBS in the portfolio.
P.ecent issues for both FHLMC and FNMA need to be considered when investing the portfolio over
the near term. It is our opinion, however, that these instrumentalities are safe and will continue to
provide the public investor with a viabie investment option. Recent confirmation of the government's
backing of these entities only adds to their safety.
ELIGIBLE BANKERS ACCEPTANCES
Bankers acceptances do have substantial credit considerations which need to be taken into account if
the City wishes to use them as a part of the portfolio. Since the City does not invest in bankers
acceptances and their use would require additional resources, the City should consider removing
them as an eligible investment option.
I~~
~~
CITI' OF SOUTH SAN rRANCISCO
-13-
COMMERCIAL PAPER
The City should add language requiring ashort-term credit rating of A-1 or the equivalent, as
authorized by state statute. The maximum maturity limitation per statute is 270 days.
The policy should state the requiremE;nts that an issuing entity be organized and operating within the
U.S. as a general corporation, have total assets in excess of X500 million, and if the entity issues debt
other than commercial paper, such debt must have along-term rating of AA- or better. No more than
25 percent of the portfolio should be held in commercial paper, and MBIA further recommends that no
more than 5 percent be held in any one issuer.
MBIA recommends additional safeguards with respect to commercial paper issuers, which include the
following:
• Developing a list of approved issuers and only purchasing commercial paper issued by those
approved issuers.
^ Requiring Investment Committee approval of the list of issuers on a periodic basis.
• Prohibiting purchases of commercial paper issued by a firm on negative credit watch.
^ Determining the steps to take should an issuer be placed on credit watch or downgraded while
the City holds its commercial paper. These steps would include making a sell or hold decision.
The City should outline instances in which the paper would be held to maturity (for example, if the
maturity date was in the near future} or when the commercial paper would be sold. The City
should require liquidation if the commercial paper issuer is ultimately downgraded.
Note: these recommendations will require additional resources on the part of the City. Credit
research and credit monitoring require both time and a source of credit information. There are no
commercial paper holdings in the March 31, 2008 portfolio. Unless these resources can be provided,
the City should prohibit the use of commercial paper and eliminate these securities from the fist of
authorized investments in the investment policy.
NON-NEGOTIABLE CERTIFICATES OF QE:POSIT
There are no non-negotiable CertifiCaIe9 Cf deposits In ti to IVIarCh 3 i , 2vve piJi l vll'J. TI ieSe
investment vehicles are illiquid and the City should consider eliminating this investment alternative,
from the list of authorized investments.
REPURCHASE AGREEMENTS
Currently, this section only authorizes repurchase agreements with banks. This strategy could lead to
some counterparty risk if the banks credit rating should drop dramatically. The City should require
that counterparties to repurchase agreements be primary dealers. In addition, the City should
consider adding credit criteria for approved firms. For example, the City may require a minimum
short-term rating of A-1 or the equivalent and along-term rating of A or the equivalent. The approved
Bond P~~larket Association's master repurchase agreement must be executed and on file prior to
entering into these transactions.
The City may wish to limit acceptable collateral to U.S. Treasury, agency or instrumentality securities.
Also, a daily mark-to-market should be required for repurchase agreement collateral to ensure that
the desired margin level of 102 percent is maintained. Repurchase agreement collateral should be
limited to 10 years, and the maximum term for the repurchase agreement is 90 days. The City should
require that collateral securities be delivered to its safekeeping bank on a delivery versus payment
basis.
There are no repurchase agreements in the March 31, 2008 portfolio.
~`~ CITY OF SOUTH SAN FRANCISCO
-14-
STATE OF CALIFORNIA LOCAL AGENCY INVESTMENT FUND (LAIF)
The City may choose to state that investments in LAIF are authorized pursuant to California
Government Code Section 16429'1. This language eliminates the potential for referencing an
outdated maximum investment amount.
SAN MATED COUNTY INVESTMENT POOL
Currently, the San Mateo County Pool (SMCP} is a permitted investment and the City has 15 percent
of its assets in this pool. Our review of the April 30, 2008 holdings of the pool uncovered several
concerns. The City's investment staff uses the pool as a cash equivalent based on the City's ability to
have daily access to its funds. However, some caution should be taken as the pool reports its
weighted average duration as 1.6 y~sars (584 days} and its average maturity (after adjusting for the
reset of the floating rate securities) as .8 years (292 days). In addition, the pool has invested in some
securities with maturities as long as five years. While the County has always provided funds back to
the City as if the pool had a fixed nE:t asset value (NAV) of one dollar per share, it is unlikely that, in
the event that the pool has substantial fosses that it will be able to maintain this practice. If they
operated as a money market fund with a fixed NAV you could put one dollar in and get one dollar
back plus interest. The SEC places requirements on all of the money market funds that they regulate
(SEC rule 2a-7), limiting the weighted average maturity to a maximum of 90 days and a maximum
maturity of 13 months. The only exception is variable rate notes (VRN) which can have a maximum
maturity of 26 months. If the fund was to be rated AAAm by Standard & Poor's the weighted average
maturity would be limited to 60 d<~ys. The reason for the restrictions is that funds with longer
maturities have greater exposure to interest rate risk. Therefore, the fund with longer maturities can
not claim that if you put one dollar in you can get one dollar back with interest. If the pool were under
SEC regulation, the pool would be required to have a fluctuating net asset value, which means the
price if its shares would float, just like a stock. It must be noted that the pool is not under SEC
regulation nor is the pool currently rated by a rating agency. However, the pool does operate under
GASB 31 requirements, which requires all non-2a-7 like pools to report their fluctuation in NAV.
It is our recommendation that the City consider the use of the pool not as a cash equivalent or money
market substitute, but rather as an investment in a mutual fund with a fluctuating NAV. Policy
ianguage would need to be changed to reflect that view. In addition, we would recommend that the
City limit its exposure to any mutual fund to no more than 5 percent of the Dortfolio.
In addition to the market risk concerns, we have some additional concerns about the credit quality of
the underlying securities within the pool's portfolios. Based on the holdings as reported on April 30,
2008, the pool has considerable exposure to lower quality securities. One security in the portfolio
currently violates state statutes and several others are very close to the lower limit. Our
recommendation for al! public entitiE:s that wish to use corporate securities is that they be AA- or
better. See more information on medium-term notes below. The County pool has approximately 24
percent of its assets in securities with ratings below AA- and 11 percent of its assets at this lower limit
of A-. The City should consider whF:ther it is comfortable with this considerable exposure to lower
quality credits.
MONEY MARKET MUTUAL FUNDS/ LOCAL GOVERNMENT INVESTMENT POOLS
The City should clearly define the criteria for investing in money market mutual funds and local
government investment pools. For example, the fund must be registered under the Investment
Company Act of 1940 and it must be "no-lead" (meaning no commission or fee shall be charged on
purchases or sales of shares). The fund must strive to maintain a constant daily net asset value per
share of one dollar and invest only in securities and obligations authorized in the applicable California
statutes. We recommend a minimum rating o` AAAm by at least one rating agency. The aggregate
investment in money market mutual funds should not exceed 20 percent of the City's total portfolio,
with no more than 10 percent in any one fund. MBIA recommends that mutual funds, excepting
money market mutual funds, be excluded from the list of authorized investments.
&~"~ ~ ~
CITY OF SOUTH SAN FRANCISCO
-1/-
MEDIUM-TERM NOTES
Medium-term corporate notes have substantial credit considerations which need to be taken into
account if the City wishes to use them as a part of the portfolio. Due to the limited staff and the credit
consideration associated with these securities the City should consider removing them as an eligible
investment option. There are no medium-term notes in the March 31, 2008 portfolio.
If the City continues to include MTNs as an investment option, we recommend that the policy
guidelines should clearly state whether a split rating is acceptable, or if every rating agency that rates
the issuer must fall within the A or equivalent guidelines. The City also should define whether a rating
of A or the equivalent allows the purchase of bonds rated A- or the equivalent. It is MBIA's
recommendation that the City take the conservative approach of requiring at least AA-, and that A- is
not an acceptable credit rating for thE: portfolio. By requiring a minimum credit quality that exceeds the
state requirements, the City can protect its portfolio from violating the statute should some credit
migration occur. Also, we recommend that the City not purchase bonds with a split rating.
The maximum maturity for medium-term notes per statute is 5 years. Authorized issuing corporations
must be organized and operating within the U.S., or be depository institutions licensed and operating
with the U.S. The aggregate investment in medium-term notes should not exceed 30 percent of the
portfolio with no more than 5 percent per issuer. Language should also be provided to guide City staff
in the event of negative credit migration.
For additional comments on the actual use of corporate notes in the portfolio, see the section on
portfolio management below.
DEPOSITORY SERVICES
As noted above, 10 percent of the portfolio is held at First National Bank of Northern California. A
copy of the bank's Highfine Peer Group Rating for key financial data is included in Appendix #1.
Based on March 31, 2008 data the E3anks overall rating is in the lower quartile of its peer group. The
bank has had strong capital adequacy relative to its peer group while earnings have been
substantially below average in the last quarter. The report also shows that the bank's liquidity is good
and above average compared to its peers. The bank has had significant deterioration in loan quality
due to a growing percentage of norl-performing loans which has placed it at the bottom of its peer
group for loan quality. The bank appears to be experiencing some financial difficulty due to the
deterioration in loan quaiity. If this trend continues it could reduce both liquidity and capital in the
future. Like any other corporate crediit the bank's financial strength must be monitored. That said, we
recommend that the bank deposits be treated as any other corporate exposure and be limited to 5
percent of the portfolio assets to any one depository.
QUALIFIED DEALERS AND INSTITUTION:)
The City should consider addressing the unique criteria applicable to these groups separately, with
one section for the Selection of Broker/Dealers and a second section for the Selection of Banks. Both
sections should reference appendix items for current listings. The third paragraph requires brokers to
certify with respect to due diligence and employee training. It is our experience that few, if any,
brokers will provide such a certification. Most major brokerage firms will certify only having received
and reviewed a client's investment policy. To maintain a high quality brokeridealer pool, we
recommend that investment policy language be modified to reflect what can be reasonably expected
from brokeridealer confirmations. An example might read:
The Treasurer shall maintain a list of broker/dealers approved for investment purposes, and it
shall be the policy of the City to purchase securities only from those brokers and the firms they
represent. Each approved broker/dealer must possess an authorizing certificate from the
California Commissioner of Corporations as required by Section 25210 of the California
Corporations Code. The firms they represent must:
1, be recognized as Primary Dealers by the Federal Reserve Bank of New York or have a
primary dealer within their holding company structure, or
2. report voluntarily to the FedE;ral Reserve Bank of New York, or
b
~~~ CITY OF SOUTH SAN FRANCISCO
-16-
3. qualify under Securities and Exchange Commission (SEC) Rule 15c3-1 (Uniform Net Capital
Rule).
Each authorized broker/dealer shall be required to submit and annually update a City approved
Broker/Dealer Information Request form that includes the firm's most recent financial statements.
SAFEKEEPING AND CUSTODY
The policy should require that a safekeeping agreement be executed with each approved custodian
bank prior to using that bank's safekeeping services. The City's current language appropriately
reflects the requirement of DVP delivery, third-party safekeeping, and perfected ownership.
Repurchase agreements should be deleted from the exceptions listed in the first paragraph and
should be held by a third party safekeeping bank. We also recommend "trust department" be deleted
from that same sentence as they are more expensive than custody departments since their fee is
usually a percentage of the assets held. Most large banks have custody departments that charge
based on the number of holdings and transactions. The use of a custody department is considerably
less expensive.
COMPETITIVE PURCHASES
This is a well written section and is vitally important to the performance of the portfolio. It is very
unusual for a section like this to be written into a policy, especially one with a clause requiring a
written record be made of all bids for each transaction and that the records be maintained. If this
policy is strictly followed it will undoubtedly add to the performance of the portfolio. In our interview,
the City Treasurer and Finance Director confirmed their practice of soliciting competitive bids and
maintaining documents relating to investment quotes for six months.
COLLATERALIZATION
This section should include the types of acceptable collateral and a mandate that all collateral be held
by a separate third party for repurchase agreements and in a separate account for certificates of
deposit.
ETHICS AND CONFLICTS OF INTEREST
Language should be added stating that members of the investment committee must file a copy of
Form 700. This requirement includes the City tvianager, Treasurer, Deputy Treasurer and the Finance
Director who file Form 700 annually.
INTERNAL CONTROL
We recommend that the investment: committee and the auditor take on a greater role in helping to
review and set the internal controls for reporting, implementation, and reconciliation of the investment
transactions. The auditor should have no role, however, in setting investment strategy or in revising
the investment policy. Since these responsibilities are not currently addressed in the auditor's
contract, they would require additional resources should they be included.
REPORTING
A section on portfolio performance should be added to the requirements for reporting. as discussed
above. The current benchmark may not be the most appropriate benchmark for the portfolio as the
weighted average maturity of the portfolio is often more than 90 days. The City should consider using
a Treasury security index that corresponds more closely to the weighted average maturity of the
portfolio as a comparative benchmark. The description of reporting requirements in the current
investment policy are incomplete. Although the quarterly investment reports do include all
requirements listed in California Government Code Section 53646, we recommend this section of the
policy be expanded to include a list of all of such requirements. The list might look something like:
The quarterly reports include the following information:
1. Investment type, issuer, date of maturity, par value and dollar amount invested in all
securities, and investments and monies held by the City;
2. A description of the funds, investments and programs;
~~ CiTY OF SOUTH SAN FP.ANOISCO
17-
3. A market value as of the date of the report (or the most recent valuation as to assets not
valued monthly} and the source of the valuation;
4. A market value as of the date of the report (or the most recent valuation as to assets not
valued monthly) and the source of the valuation;
5. Overall portfolio yield based on historical cost;
6. A statement of compliance v~rith the investment policy or an explanation for non-compliance;
and,
7. A statement of the City's ability to meet expenditure requirements for six months, and an
explanation of why money will not be available if that is the case.
POLICY REVIEW
The City's investment policy already requires the investment policy reviewed by the Investment
Committee and adopted by City Council, on an annual basis. Both criteria are reasonable and
appropriate to ensure that the docurnent remains current with changes in legislation and accurately
reflects the City's investment objectives and constraints.
APPENDIX ITEMS
The City should add as appendix items: Authorized Personnel, Approved Brokers, and Approved
Depository Institutions.
.~~ CiTY OF SOUTH SAN FRP.NCISCO
_Zg_
Portfolio Management
The City generally follows a passive portfolio management strategy. Securities are purchased with
the expectation that they will be held to maturity. As of March 31, 2008, the City's operating portfolio
was invested in a combination of callable instrumentality securities, LAIF, San Mateo County Pool,
and cash vehicles. The following comments and analyses are based on the operating portfolio's
composition as of March 31, 2008.
ACCESS TO MARKET INFORMATION
The investment staff does not have access to a market system for information, such as Bloomberg.
Market systems provide real-time market information, including the ability to view broker.~dealer
inventories, security pricing, and credit information. Although these types of systems are expensive,
the City should recognize the disadvantages of not having access to relevant market information.
CREDIT ANALYSIS
Without access to a market information system, the City must rely heavily on credit ratings provided
by brokers at the time a corporate bond (or other security that carries credit risk) is purchased. While
the City currently does not directly oven any corporate notes, as noted above, the San Mateo County
Pool has considerable corporate note exposure. The City is required to conduct monthly reviews of
credit ratings and credit outlooks for Each corporate holding. The information could be requested from
the brokers on a rotating basis so that the broker who sold the bond is not always providing the City
with that security's credit review. Without access to market information or investment advisory
services, the City is reliant on the approved brokers for continuing credit review. It is our opinion that
this is an inadequate arrangement for the timely monitoring of credit migration. Until the City has an
independent source for credit monitoring, we would recommend that the City Treasurer limit
investment purchases to Treasury, government agency, and instrumentality securities.
It should be noted that the rating for all securities in the City's March 31, 2008 portfolio meet the
required credit ratings.
SIZE OF INVESTMENT TRANSACTIONS
The City should generally limit trades to a minimum of $2 million par value for instrumentality
securities. Maintaining fewer instrumentality securities will result in a more efficient portfolio and less
administrative costs associated with tracking and reporting on the securities. This recommendation
should not jeopardize the City's objective of maintaining adequate liquidity; since a fairly large cash
balance has typically been held, maturities are not necessarily purchased for any specific cash flow
purpose. The portfolio is currently being managed very efficiently with regard to transaction size. Our
recommendation is that the City continue to purchase securities in larger blocks to promote efficiency.
CASH FLOW FORECAST
Our recommendations for this section may require the City to provide the investment staff with
additional resources to complete these recommendations. The City of South San Francisco is in the
enviable position of having a fairly normalized cash flow stream. Nonetheless, it would be beneficial
to the City to carefully consider cash flow projections for the portfolio, but for varying benefits.
Defining the portfolio's cash flow over the last few years and making appropriate projections would
enable the City to truly identity the portfolio's core funds. This ongoing effort could be greatly
rewarded if the City were to more effectively manage its liquid funds. For instance, if more cash
vehicle funds were invested in term securities when interest rates were higher, the City would have
benefited from relatively more attractive yields on longer-term securities in the portfolio as rates
changed.
Approximately 50 percent of the portfolio (roughly S53 million) was held in liquid investments as of
March 31, 2008, assuming that the funds in the SMCP are considered liquid funds. Given the fairly
large allocation to cash holdings, it is necessary to carefully determine the appropriateness of the
~~ CITY Or SOUTH SAN FRANCISCO
-19-
strategy for those funds. It is worthwhile to be prepared for market opportunities that may arise
relating to these funds. The graphs below show the maturity distribution of the portfolio.
Matturity Distribution - To Final
6C% -
so°r° -
ao% -
sz.e r
30°e -
20.0 :o
X7.0°m-
20% -
I 0 % 5.0
4. C'%
2.0%
0.0°~0
0 - 3 months 3 - 5 rrnnths 6 - 12 imnihs 1 - 2 years 2 - 3 years 3 - 4 years 4 - 5 years
Maturity Distribution - To Call
60% -
I 52.0
50 %
40
I
I
30
25.0
20°.6 17.0%
10%
4.0
~ ,~
i
Ooo _~. - _-
-_, 2.0
_. - __ __,_ __ _ _._.-_.
-
_ -..-- -- --
0 0% 0 0
-
,-- r
0 - 3 months 3 - E months E - 12 months 1 - 2 years 2 - 3 years 3 - 4 years 4 - 5 years
PORTFOLIO I-fOLDINGS -CALLABLE INS"fRUMENTALITY SECURITIES
As of March 31, 2008 the portfolio was comprised of nearly $54 million in U.S. instrumentality
securities, which was 50 percent of the portfolio. A small portion of the portfolio has call features. It is
true that callable securities offer enhanced yield relative to the non-callable securities at the time of
purchase. Callable instrumentality securities are an extremely viable alternative when investing public
sector funds. However, the City may wish to limit the overall exposure to callable securities in order to
insulate the portfolio from the reinvestment risk created by callable securities.
Callable securities subject the portfolio to significant reinvestment and extension risk. As interest
rates decrease, callable securities are called by the issuer. The proceeds from the called security
must then be reinvested at the lower prevailing market rates. Alternatively, as interest rates increase,
callable securities are subject to exi:ension risk in that they may not be called and instead may be
redeemed upon maturity only. This results in no principal cash flow from the investment c.antil maturity ,
thereby reducing the opportunity to participate in the rising interest rate environment.
Even with the risks associated with these securities, they remain a common investment fcr public
sector portfolios. The structure selected for callable securities should be adjusted given changing
~~+
CITY OF SCIJTH SAN FRANCISCO
_7~_
market conditions, with longer maturities and call protection purchased when rates are high, and
shorter maturities and no call protection purchased when rates are lower. Taken to the logical
conclusion, non-callable or bullet sE;curities should be purchased to lock-in yields when rates are
high. In general the City should limit its exposure to callable securities to 20% of the portfolio.
The City's instrumentality sector is comprised mainly of Federal Home Loan Bank (FHLB) issues.
Approximately $33 million is held in FHLB, which represents over 62 percent of the instrumentality
holdings and 31 percent of the overall portfolio. We recommend limiting individual instrumentality
exposure to 20 percent per instrumentality issuer. The FHLB exposure seems especially high when
considering that the Federal National Mortgage Association (FNMA) exposure, the next largest
holding, is only $14 million; Federal Farm Credit Bank (FFCB) is $5 million; and Federal Home Loan
Mortgage Corporation (FHLMC) is $'I million. The City should consider improving diversification of the
instrumentality sector of the portfolio to protect the portfolio from headline risk that could impact a
particular issuer.
Allocation of Funds by Investment Type
Cash, 9.0%~ Agency Callable,
~ 5.0%
/J
San Mateo Pool, ~~
15.0% \ ' ~~~.
I~_~~
;,
i~ ~, Agency Non-
~ Callable, 45.0%
LAIF, 26.0%
Source: City of South San Francisco -March 31, 2008
Allocation of Funds by Issuer
FFCB, 5.0%
LAIF', 26.0% -
FHLB, 31.0%
San Mateo Pool,
15.0°~° FHLMC, 1.0%
FNB, 9.0% FNMA, 13.0°~0
Source: Cit`~ o` South San Francisco -March 31; 2008
;E
~d CITY OF SOUTH SAtJ FP,ANCISCO
-21-
PORTFOLIO HOLDINGS -MANAGED POOL ACCOUNTS
The City held a total of $16 million in San Mateo County Pool and over $27 million in LAIF as of
March 31, 2008. In total, cash vehicles represented nearly half of the portfolio.
LAIF certainly provides a competitive rate of return for California entities. Although we are
comfortable with LAIF as a cash vehicle for the portfolio, the City should develop a cash flow forecast
for investing and reduce its exposure to LAIF as market conditions merit.
The San Mateo County Pool was mentioned earlier with respect to both interest rate and credit risk.
The performance of the pool does not appear to be significantly greater than the performance of
LAIF. In fact, for three of the four quarters reviewed, the performance of the pool was less than the
performance of LAIF. The only quarter with better performance was the March quarter, which was
followed by a 1.22 percent drop in April performance. Given the risks outlined above, a reallocation of
assets from the pool to LAIF may be worthwhile as an interim strategy, ft must be noted that LAIF has
a similar interest rate risk profile i:o the SMCP. However, we believe that that state has more
resources available to cover losses should that need arise.
~ CITY OF SOUTH SAN FRANCISCO
_7~_
Inv€?stment Perfarmanae
PORTFOLIO PERFORMANCE ANALYS{S
As a way to benchmark the City of South San Francisco's portfolio performance, we compared the
City's investment performance both in terms of risk and return with similar public sector portfolios and
to two composite returns. A description of that process and the results of the reviews are provided
next.
This City's investment performance as recorded in the quarterly reports was not correct. The returns
for LAIF and the San Mateo County Pool were not correctly updated at each quarter end. As an
example, for the March 31, 2008 report, LAIF was shown as having a return of 4.96 percent and the
SMCP return was reported as 4.65 percent. The actual returns for the month of March 2008 were
3.62 percent and 4.49 percent respectively. (We were unable to determine if the returns for the bank
deposits were correct.) The following performance analysis contains the adjusted performance
numbers for the fast four quarters. l"he performance and weighted average maturity numbers have
been averaged for simplicity.
The first step in our review was to select a number of MBIA-managed portfolios to use as
benchmarks. We gathered portfolios with similar investment objectives into composites to
demonstrate the investment performance of a particular type of portfolio and to offset the effects of
differing cash flows for each of the portfolios. These composites show the average performance for
portfolios with similar portfolio management styles.
While composite performance can be used to illustrate the average performance available within a
particular management style, portfolios that deviate substantially from the average can also distort it.
In addition to the composites, several individually managed portfolios have been selected for use in
the review. These portfolios are selected because they closely match the portfolio being analyzed in
terms of the type of entity, size of portfolio, asset allocation, investment policy, state statutes, and
weighted average maturity of the portfolio. While these individual portfolios may not match the
portfolio being analyzed in all of thE; aspects outline above, they are chosen because they closely
match the objectives of the portfolio being analyzed and can help demonstrate the performance of
MBIA's portfolio management style.
BENCHMARKS USED
Two MBiA composites are used as overall benchmarks for performance: 1) Short Composite that is
comprised of 17 public sector portfolios and has a weighted average maturity that ranges between
275 days and 650 days, depending on market conditions, and 2) Intermediate Composite that is
comprised of 38 public sector portfolios and has a weighted average maturity of 465 days to 975
days.
Two of our individually managed California portfolios are used as more specific benchmarks of
performance: Portfolio #1 has X29 million in portfolio assets which are allocated between U.S.
Treasury and government agency securities, commercial paper, and cash. Portfo{io #2 has X21
million in portfolio assets which are allocated between U.S. Treasury and government agency
securities, and cash.
The performance of the four MBIA benchmarks is compared to the performance of the City's portfolio
on a quarterly basis for each of the last four quarters for the period ending March 31, 2008. The
evaluation considers both return (sere Graph #1) and the degree of market risk (see Graph + 2). The
degree of market risk is measured by the weighted average maturity of the portfolios. The following
graphs illustrate the results of the performance review.
.&~ CITY OF SOUTH SAN FRANCISCO
-23-
Graph #1
Return ~r~afysis -June Q7 to March 08
5.50
4.80%
5.00°0--- 4;~g% ---
4.50 %---
4.00%- - ---------
4.97%
3.50 %~-- - _ _ -- ------ -
3.00% -- __ --- - -~ .. _.. ---~--- -- -::-
Short intermediate Portfolio #1
Composite
Graph #2
4.$7%
Portfolio #2
4.72% _ -
--~
South San
Francisco
Market Risk Profile -June o7 to March o8
(based on weighted average maturity)
700
600
500
Days400
300
200
100
Short
Composite
~e~view and C~ncia~sian
~~ CiTI' OF SOUTH SAN FP..ANCISCO
_7~_
It is MBIA's view that we have been at the top of the interest rate cycle for the last several years, so
we have been extending portfolio durations, in spite of the inverted yield curve, in order to lock in
interest rates. A basis point (bp) is one hundredth of a percentage point (0.01 %). The return on the
MBIA Short Composite is 6 basis points (.06%} higher than the return on the portfolio for the City; the
MBIA Intermediate Composite is higher by 8 basis points (.08%). For the individual portfolios, both
California public entities, have returns that are 25 basis points higher and 15 basis points higher
respectively. For example, assuming a $50 million portfolio, an additional 6 by in earnings translates
to an additional $30,000 in income, 8 by would earn $40;000 in additional income, 15 by increases
earnings by $75,000, and so on.
All of MBIA's benchmark portfolios have longer weighted average maturities than the City's portfolio.
The two individual portfolios used as benchmarks have weighted average maturities that are 20 days
and 291 days longer than the City's portfolio. As noted above, the weighted average maturities on
MBIA's individual clients' portfolios have been extended in order to insulate the portfolios from future
movement in interest rates. They are well diversified across the yield curve, which will help to reduce
the return volatility associated with changes in interest rates.
~~ CITY OF SOUTH SAN FRANCISCO
-25-
l~vestmer~t ~cco~anting and F2eporting
AVERAGE YIELD
It appears that the City currently evaluates portfolio performance based upon the weighted average
yield of the holdings. MBIA recommends that the City calculate a rate of return on a monthly basis.
The portfolio's rate of return would be generated based on the income earned divided by an average
cost figure of the dollars invested.
A return figure represents the earnings over the entire period, rather than an average yield figure
which represents one point in time. A, return figure will more accurately reflect the income reported in
the City's financial statements. In addition, a return figure shows the impact of any realized gains or
losses on the portfolio for the period in which they are taken. These figures can "get lost" when
evaluating performance based solely on average yield.
The effective rate of return provided on the reports is likely a version of annualized monthly return.
The City staff should understand the return calculations provided through the investment software
and variable rates, like those for LAIF, must be updated on a consistent basis.
CALCULATING PORTFOLIO RETURNS
The City uses the Sympro accounting software to track portfolio holdings. The Sympro system is
capable of calculating the components of income on both an amortized cost and fair value basis.
MBIA recommends that the City consistently calcu-ate and record earnings on investments on either
the fair value or the amortized cost basis. On a fair value basis, the components of investment
income are the interest earnings frorn the stated coupon rate and any change in the fair value of the
security on aperiod-over-period basis. It is necessary to enter the month-end or period-end prices to
calculate the change in fair value. The City currently uses prices provided by its custodian bank, Bank
of New York. Those prices are updated quarterly. Vliithout access to a market system or investment
advisory services, pricing from the City's custodian provides only a reasonable estimate of the market
value of the portfolio holdings.
The components of income on an amortized cost basis are interest income earned from the coupon
on a security, accretion of discount, and amortization of premium. If a security is sold prior to maturity,
a gain or loss may be realized. It would be most efficient if the City's investment software were used
to calculate all of these components of investment income. Each component should be recorded on a
monthly basis to accurately reflect the portfolio's performance. If investment income is recorded on an
amortized cost basis throughout the year, adjustments to the fair value basis of the portfolio would be
required at fiscal year-end to meet GASB No. 31 reporting requirements.
These recommendations may requirE; additional resources to be implemented.
CALLABLE SECURITIES
The City currently does not disclose to the reader of the investment reports the callable
characteristics, if any, of the securities held. It is important that the City disclose which bands are
callable in the portfolio. It would be helpful if the next call date was displayed on the portfolio holdings
report as well as the final maturity date.
Callable securities can significantly impact the weighted average maturity of the portfolio. In order to
reflect the impact of callable bonds in the portfolio, the City should calculate a weighted average
effective maturity as well as a weighted average final maturity. The effective maturity of the portfolio
would reflect current market conditions and the pricing of the callable securities. If a callable bond
was priced to be called on the next call date, the effective maturity would be the time until the next
call date. The final maturity of the bond would still be disclosed as the security's final maturity date.
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~~ CITY OF SOUTH SAN FRANCISCO
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By calculating both the weighted average final maturity and the weighted average effective maturity of
the portfolio, the City discloses the impact of callable bonds in the portfolio. It is especially important
to consider the impact of these securities given the fairly large allocation to callable bonds in the
instrumentality sector of the portfolio. As of March 31, 2008, the operating portfolio has a weighted
average final maturity of 361 days, while the effective maturity was actually 316 days. 'JVithout
reporting the effective maturity, the reports do not clearly convey the true maturity horizon of the
portfolio.
In a declining interest rate environment, looking only at the weighted average final maturity of the
portfolio may be misleading, since the City may lose many of the callable holdings on their first call
date. The final maturity alone would overstate the portfolio's most likely maturity. In a rising interest
rate environment, the effective maturity would approach or equal the final maturity of the portfolio. By
disclosing the effective maturity, the City shows how the market is currently pricing the City's callable
holdings and the City's maturity risk ~-ssociated with those holdings.
The City should and appears to disclose the yield-to-worst for callable securities. For example, if a
callable is purchased with a premium, the yield-to-call is lower than the yield-to-maturity, and the
more conservative yield-to-call should be reported. If a callable security is purchased at a discount to
par, the yield-to-maturity is lower than the yield-to-call, and the City should reflect the lower yield-to-
maturity.
MARKET VALUES AND UNREALIZED GAIINS AND LOSSES
The City's reports disclose a market value and book value for each holding. !t would be helpful to also
show the unrealized gain or loss per security as well as the overall portfolio. Reporting this
information provides the reader with important information about the construction and performance of
the City's portfolio.
CREDIT RATINGS
The City should prepare a monthly report summarizing the credit ratings for each security in the
portfolio. This report should be reviewed as part of the general oversight of the portfolio. Such
disclosure is required annually by GASB Statement 40. At this time, the City provides the information
quarterly which complies with GASB statement 40.
DIVERSIFICATION
It would be helpful to capture the diversification of the portfolio per issuer. This is also required by
GASB Statement 40. Such disclosure is an effective tool for managing exposure to issuers in the
portfolio.
ACCURACY AND TIMELINESS OF INFORh9ATI0N
It goes without saying .that the reader of the City's reports must be able to rely on the accuracy of the
information.
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i
~~~ CITI' OF SOUTH SAN FR,4NCISC0
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Conc6usior>;s
MBIA has made a number of recommendations intended to strengthen the City of South San
Francisco's current cash and investment program. The recommendations include the following:
OVERSIGHT AND STRATEGY SETTING
^ Improve the oversight provided by the Investment Committee
^ Enhance the reporting provided to City Council
^ Form a small group to set daily portfolio strategy on a continuing basis
INVESTPJIENT POLICY AND PROCEDURES
^ Clearly define the securities that are authorized for purchase
^ Formalize steps to be taken in the event of a credit downgrade
^ Allow for the safekeeping of :>ecurities with a custody department
• Change repurchase agreement to primary broker/dealers
• Set policy on the use of the county pool
PORTFOLIO MANAGEMENT
^ Reduce exposure to the San Mateo County Pool
^ Develop a cash flow for investment purposes
^ Increase diversification of bank deposits
^ Prohibit exposure to medium-term notes without enhanced credit capabilities
^ Diversify exposure to instrurrlentality securities
^ Reduce the liquidity of the portfolio
^ Extend the duration of the portfolio, if possible
INVESTMENT ACCOUNTING AND REPORTING
^ Calculate and understand a monthly rate of return
^ Calculate an effective and final maturity for the portfolio
^ Create monthly reports of securities purchased, sold and matured
^ Create monthly reports on credit rating for securities held in the portfolio
^ Include the dealer bids for all transactions in each monthly report
CITY OF SOUTH SAN FRANCISCO
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