How important is securities lending to Illinois in terms of income?
There are some fiscal problems within Illinois at the moment as the governor and the state legislature have failed to agree on a budget for the 2016 fiscal year, which began on 1 July 2015. While unfortunate, it’s the longest this state has ever gone without a budget.
This has impaired our ability to continue our programme of asset liability management because of the uncertainty regarding revenues and the timing of expenditures. There is still no official budget seven months on and all forms of state spending have been significantly reduced.
The portfolio of securities holdings now to has a much greater amount of cash back than was previously necessary to cover large dollar outflows and reduced revenue inflows. The lower level of our portfolio holdings has had an adverse impact on securities lending incremental income, but it still makes a solid contribution to our overall portfolio return.
At the same time, the state overall has lost additional revenue received from a temporary personal income tax and corporate tax increase that was enacted by law in January 2011 and expired in December 2015.
It’s estimated that state revenue fell by $2.2 billion for the second half of fiscal year 2015. A rough estimated decline in revenue for fiscal year 2016 is $4 billion after the tax expired. Without the passage of a normal budget for fiscal year 2016, our conservative approach to keeping overall maturities short has had an adverse impact on our asset management and liability programme.
On the positive side, our net investment return from securities lending has climbed from the high 20 basis points (bps) to the mid-30 bps to 40 bps range, and in a low interest rate environment, our securities lending income has had a positive impact on our portfolio return.
What is your strategy under these conditions?
Our investments are typically in US treasury bills and we do buy a fair amount of US government agency coupon securities. Our strategy for short-term maturities is aided by conversations with our agent lender who indicated US treasury bills would do well in securities lending. We have done very well following this strategy. Our agent lender has indicated that this will likely continue. Our average net spread on loaned US treasury bills is 30 bps and that is very good.
For our asset liability matching programme, we look forward 12 months at a time and use US treasuries to match liabilities in monetary outflows from the state treasury—this translates into roughly $24 billion for a fiscal year or $2 billion per month on average. While somewhat constrained now, cash flows have been adequate to meet payment obligations.
We invest in US treasury bills to avoid carrying the cash forward through repo. Even with the Federal Reserve’s interest rates so low and treasuries coming in at a low rate, our net take has remained at 30 bps to 40 bps since the programme began.
More recently, we have had to shorten portfolio weighted-average maturity in order to be more liquid, given our unusual fiscal problems, so we are taking a conservative approach of fewer than 90 days.
In terms of indemnification, we are covered on both sides of securities lending transactions. Our agent lender offers full indemnification on the loan side and also on the cash reinvestment side—that reinvestment is in short-term repo agreements.
Our utilisation rate has held at around 80 percent throughout the past year, although it did drop a little towards the end of the 2015 calendar year.
Do you require full indemnification of your securities lending transactions?
When we posted our request for proposal (RFP), we didn’t contemplate the concept of indemnification from an RFP responder. One of our RFP responders did offer it and at the time we determined it to be viewed as ‘value added’. Reporting and services offered by the responders were equally as important in our review of the responses received. We vetted the responder’s abilities in these areas very critically to ensure that our office received the best package available.
What’s being done about the state’s budget?
State treasurer Michael Frerichs does have some influence as one of the five constitutional officers. Treasurer Frerichs is a former state senator and is keenly aware of the workings of the state budget as well as the detrimental effects of no budget. He has a very clear understanding of the state’s fiscal issues and the need for having a budget in place for transparency and the effective management of the state. He has communicated his knowledge and perspective to the parties involved. The actual decision to agree on a budget remains with the governor and the state legislature.
Did your office, as a public body, have any problems launching a securities lending programme?
This Office of the Illinois State Treasurer renewed its efforts to establish a securities lending programme in the summer of 2007 through a state-mandated RFP process. In January 2008, after attempting an unsuccessful experience many years ago, our office officially engaged in a new securities lending programme. In the mid 1990s, we had to deal with the backlash from the Orange County debacle. Reverse repo was used by that entity, as well as other non-standard and high-risk investment vehicles, to engage in many unsound investment practices. What was meant to be a form of a money market fund for local governments eventually became a very precarious situation and that escalated to the point where it bankrupted the county.
The law for securities lending was actually passed prior to the Orange County situation. The law permitted the state treasurer to engage in securities lending. However, Orange County followed soon thereafter. As a result, there was an aversion to be seen to be doing anything like reverse repo, which unfortunately included securities lending. Over the passage of time, a greater and more positive understanding of securities lending prevailed.
Reverse repo is very different from securities lending, but the misunderstanding persisted and our conservative strategy just was not a good fit at the time we attempted securities lending several years ago. We discontinued a programme that was in place in the early 2000s.
When we started our current programme, we were on cusp of one of the greatest financial crises of recent memory, but we didn’t actually have any problems and didn’t lose any money because we weren’t in any collateral pools. My understanding is that losses were incurred in some programmes involving collateral pool for certain entities.
Since inception it’s been very successful and our agent lender is very good at providing us with an excellent service. This is especially true for the reporting requirements because, as a public body, transparency, following investment policy and state laws are all of primary importance.
There are lot more regulations in the pipeline in the US. Is there any specific one that you find is having a significant impact?
Overall, it hasn’t affected our securities lending business. The increased regulatory emphasis on high-quality liquid assets has pushed some counterparties we do business with directly to withdraw from providing normal investing in overnight repo trades for our regular investment activity. This is not related to our securities lending programme.
Do you expect your strategy will have to change as a result of any of the regulations?
The changes in the repo market have not affected our securities lending programme, nor has the cost of indemnification, but what the future holds in either of these areas, I don’t know. We will remain vigilant and nimble to navigate through the future.
On the other hand, the Dodd-Frank Act affects us downstream from a regulatory point of view and it’s an ongoing concern for us because the full effect of it is gradually having an impact on financial markets in the US. Overall, our lending programme continues to run very well.
Do CCPs hold any interest for you as risk mitigation tool?
The use of central counterparties (CCPs) would be more of an issue for our agent lender than us specifically. It’s another area in which we have discussions with our agent lender. We will always be open to new avenues of business and more effective ways to conduct our business while we maintain adherence to our investment policy and state law.
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