LGA Lyceum

Market Outlook for Government Investors, October 2008

 
Submitted by Tamara Dzeskewicz (dzeskewiczt@pfm.com) and John Molloy, CFA, (molloyj@pfm.com), Senior Marketing Representatives, Pennsylvania Local Government Investment Trust, 800-388-4736

 

The recent upheaval that has swept the financial system leaves in its wake a radically altered investment landscape. The latest wave of financial market realignment began on September 7th when Fannie Mae and Freddie Mac were placed into a conservatorship under the Federal Housing Finance Agency. This action secured bondholders, however shareholders’ stock values fell below $1. Further upheaval followed with a flurry of bank closings, hurried mergers, and stopgap government bailouts.

A predictable flight-to-quality ensued as investors fled to the safety of U.S. Treasuries, driving their prices up and yields to new lows. While this rally will subside when normalcy returns to the markets—be it in a month or a year—other effects of the cataclysm will remain.

The Government Sponsored Enterprise (GSE) bailout, for example, challenges two conditions—ample supply and near risk-free appearance—that have made Federal Agency debt a mainstay in many short-term, fixed-income portfolios.

                If the GSEs are privatized, investing in Fannie Mae and Freddie Mac debt may remain an option only for those permitted to invest in corporate securities. In the public sector, will this lead to increased pressure on legislative bodies to expand the scope of permitted investments? If so, then additional investors may be thrust into the world of corporate credit. This could be complicated further if the privatized GSEs fail to keep their AAA rating. It is generally accepted that without some sort of government backing, the GSEs would not have maintained this top rating in recent years.

For those who invest in anything but Treasuries and Federal guaranteed debt, in-depth credit analysis will become more critical. Credit ratings alone have proven unreliable guides to credit quality as rating agencies appear to have mischaracterized the risks of a great number of investments. Over the past year, 16 AAA-rated issuers in the Merrill Lynch 1-10 Year Corporate Master Index were downgraded to AA or A. An additional 136 issuers previously rated A or BBB fell below investment grade. Downgrades are usually accompanied by an erosion of market value as investors demand higher yields for holding lower credit bonds and in some cases are followed by defaults, which produce real losses.

GSE debt could also go from plentiful to scarce. The Fannie Mae and Freddie Mac conservatorship stipulates that beginning in 2010, each must reduce its portfolio from $750-$800 billion to $250 billion at a rate of 10% per year. A reduction in Federal Agency debt supply could result in a diminished yield advantage over U.S. Treasuries.

If the GSEs become truly private corporations and/or if their debt issuance shrinks substantially, risk-averse investors may be pushed into the U.S. Treasury market. U.S. Treasury securities, however, typically produce the lowest returns of any fixed-income investment. The recent flight-to-quality pushed short-term U.S. Treasury yields to near 0.00% in September. While this is an anomaly, 3-month Treasury Bills yielded 0.26% less than 3-month Federal Agency discount notes over the past 10 years. This translates to $650,000 less earnings on a $25 million portfolio. Investors limited to the U.S. Treasury market will face additional challenges in seeking a reasonable rate of return.

                Meanwhile, the market upheaval has also resulted in a reworking of the broker/dealer and banking landscape. The top 5 U.S. broker/dealers of a year ago are now gone, continuing the trend of consolidation and globalization of the U.S. securities markets. The number of primary dealers (broker/dealers and banks that trade U.S. Government securities directly with the Federal Reserve Bank of New York) has shrunk from 31 to 16 over the past 10 years. Today, only 6 are domestic, versus 17 in 1999. In fact, in 2007, 9 of the top 20 underwriters of U.S. corporate and GSE debt were non-U.S. broker/dealers.

With fewer primary dealers, there is bound to be less competition among trading desks. This may lead not only to less attractive quotes and increase the importance of competitive security shopping, but small money managers and in-house finance teams may see the service level they receive from remaining banks and brokerage firms significantly reduced.

Similarly, consolidation of commercial banks into a small number of super-banks is likely to bring about changes in the relationship between investors and their local bank. In this new era, the largest three or four banks will control 30% to 40% of all deposits, giving them enormous power to set prices for services and diminishing their need to raise deposits in the local market. The small local/regional banks will find it increasingly difficult to remain independent as benefits from economies of scale encourage further consolidation.

 

OUTLOOK

With unprecedented worldwide government intervention in the financial markets, the outlook is partially clouded. Each action was initiated to restore stability, but that goal has been elusive to date. In the interim, risk-averse investors have preferred U.S. Treasury securities. We continue to view GSE debt, with its explicit Federal commitment of support, to be appropriate as well.

Corporate and bank obligations should be treated with the utmost caution because the full extent of the economic downturn and the interrelationships among banks and corporate borrowers is not yet fully known.

An investment approach involving discipline, rigorous credit and counterparty analysis, and prudent risk management, will be all the more critical in navigating these difficult and uncharted investment waters.

 

To obtain a PDF of this article, click here.

Connecting Contiguous Communities

Submitted By Amy Bishop, Graduate School of Public and International Affairs, University of Pittsburgh

alb199+@pitt.edu

University of Pittsburgh’s David Miller,who is the director of the Innovation Clinic at the Graduate School of Public and International Affairs (GSPIA), has a new proposal to foster communication among the 35 municipalities that share a common border with the City of Pittsburgh and the city itself.

Still lacking an official name, the initiative is centered around creating a forum, or congress, in which all 36 communities would act as equal partners in finding common ground on issues that face the Pittsburgh area.

“We note an increasing sense of common issues associated with the city and these surrounding communities,” Miller said. “GSPIA should be creating an opportunity for discussion of these issues.”

A planning meeting for the congress is set for October 31. Miller has invited a representative from each of the 36 municipalities to come together to discuss whether a congress of this scope is desired and whether it is feasible.

 “We’re creating this opportunity for these communities to see if this makes sense to them. The ultimate decision about the creation of the congress is up to the participants,” Miller said.

 So far, the idea has generated positive response. According to Miller, elected officials in these communities have expressed a growing interest in this forum and are beginning to recognize that many of the solutions to problems facing this area involve consultation across municipal lines.

According to Miller, most current intergovernmental cooperation starts at the city border and moves outward to the county border. This will be an opportunity for these common-border communities to begin a conversation that includes the City of Pittsburgh.

 The 36 municipalities invited to participate represent a total population of 680,000. Only roughly 310,000 reside within the Pittsburgh city limits. And while Miller and his team will be providing necessary research and institutional support throughout the congress, he will leave the direction of the concerns up to the participants that represent these 680,000 citizens.

 “We want the communities to drive the agenda,” he said.

 The agenda for the planning meeting includes discussing the feasibility of such a congress, topics that could be presented to the forum and an official name for the group. The congress would launch in April or May.

 “I have two main goals for the October 31 meeting,” said Miller. “First, to see that common border issues are significant and important enough to continue to have structured meetings. And second, that at the conclusion we have created a planning process for follow-up actions that includes the representatives from those municipalities, so in a way there is a handing off of the agenda from GSPIA to the group itself.”

 Questions with regard to the initiative may be directed to Ann Pollack  and the Innovation Clinic, Graduates School of Public and International Affairs, University of Pittsburgh.  (apollack@pitt.edu).

A Rare Opportunity to Reduce Real Estate Tax Collection Costs: The Time to Act is Approaching

 

Submitted by:

Gerald Cross

Pennsylvania Economy League

Central PA Division

570-824-3559

pelcent@epix.net

 

During the next few months, counties, municipalities, and school districts in Pennsylvania have a once-in-four-years opportunity to bring about savings in their real estate tax collection costs. Prior to February 15, 2009, local governing bodies can change the methods and rates of com­pensation for elected tax col­lectors, and these methods and rates will become effective for those tax collectors elected to four-year terms of office beginning in January 2010. It is time for local officials and taxpayers to begin to do their homework so that they can make the best use of this rare cost-saving opportunity.

 

           Prior analyses by the Pennsylvania Economy League (PEL) of real estate tax collection costs in more than 500 jurisdictions identified millions of dollars in potential annual savings. Jurisdic­tions were advised to shift from the traditional commission form of compensa­tion to the more appropriate salary or “per bill” payments and/or to lower their rates of compensation.

 

          These recommendations were made in part because PEL found major deficiencies in compensating tax collectors on a commission basis. Unlike salaries or “per bill” compensation, commissions are not directly related to work loads; instead, they are based on the value of the taxables and on the tax rate.

 

          An increase in the assessed valuation of a property or in the millage rate produces increased commissions, but the workload remains unchanged. Also, large tax bills generate large commissions, yet they are no more expensive to handle than small ones. PEL also found that not only are salary and “per bill” compensation more logical and more in keeping with the work performed, but these approaches tend to be less costly as well.

 

          Periodic surveys designed to document the actions of public offi­cials in a ten-county area in response to PEL’s analyses of the cost-saving opportunity revealed hundreds of thousands of dollars in continuing annual cost reduc­tions, as well as unspeci­fied savings in terms of future cost avoid­ance. The latter resulted from placing caps on compensa­tion or by freezing com­pensation at current levels in conjunction with a shift from commission-based compensation to salary or “per bill” payments.

 

           In response to PEL’s series of analyses, one county (which at one time was compensating its tax collectors on a “sliding scale” based on the number of tax bills processed ranging from $2.25 per bill down to $1.75 per bill) reduced its per bill compensation rates by 50 cents or by between 22 and 29 percent. As an example of cooperative collection, Lycoming County School Districts collect their real estate taxes under a bank lock box system that allows local tax collections to “deputize” the bank to collect school district real estate taxes.

 

          In spite of documentation suggesting the poten­tial for sav­ings, many jurisdictions failed to make any changes; in some cases the jurisdictions which failed to act were among those with the greatest potential for reducing compensation costs.

 

           Act 169 of 1998 should also prove helpful to officials in reviewing their municipal tax collector compensation. It requires that tax collectors regularly file reports with the taxing jurisdictions they serve detailing the taxes collected using standard forms provided by the state and that the tax collector’s accounts be audited annually by the duly authorized auditors of the taxing district—the elected auditors, the controller, or an independent appointed auditor.

 

Local officials can directly influ­ence the cost of real estate tax collection only by modifying the method and/or rate of compensa­tion of their tax collectors, and these officials must be prepared to act if savings are to be realized. Final action in setting the methods and rates of compensation must be taken prior to February 15, 2009.

 

This PEL News and Views notice allows local officials more than eight months to prepare to take appro­pri­ate action. PEL has long recommended the elimination of elective tax collectors and treasurers and, as an alternative, the countywide cen­tralization of the real estate tax collec­tion function. This would undoubt­edly result in a more cost­-effective approach to the collection of real estate taxes, but it would require action by Pennsyl­vania’s General Assembly. PEL continues to encourage the state legisla­ture to make changes in Pennsylvania’s tax collection laws to allow for more modern and less costly real estate tax collec­tion methods.

 

The past series of reports on tax collection costs and the opportunities for savings is an example of what PEL is all about. The full series of the 2004 PEL Tax Collection Compensation Reports can be viewed at our Website: www.pelcentral.org/Tax Collection/