Impact of Regulatory Reform on Investments, Liquidity, and Market Value

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1 Impact of Regulatory Reform on Investments, Liquidity, and Market Value Presented by: Sarah Meacham, Director 2016 PFM Asset Management LLC

2 Regulatory Reforms Basel III banking sector reform Money market fund reform GASB 79 in response to money market reform GASB 72 provides new guidance on fair market valuation 2016 PFM Asset Management LLC 1

3 Basel III Banking Regulations

4 Basel III New Banking Regulations Capital Leverage Liquidity 2016 PFM Asset Management LLC 3

5 Capital Ratio Requirements Required Capital Ratio Capital (according to new definition) Risk-Weighted Assets 16% 14% 12% 10% 8% 6% 4% 2% 0% Total Capital Requirements 15.5% 11.1% 11.8% 12.4% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% Source: JP Morgan, U.S. Fixed-Income Regulatory Update for 3Q PFM Asset Management LLC 4

6 Banks Deleverage To make banks more stable, Basel III requires many banks to increase their capital or decrease their total assets. De-Leveraging Requirements by Bank ($billion) Capital Increase (or) Asset Reduction Bank of America - - Citibank 2 (49) JP Morgan 10 (204) Wells Fargo - - Goldman Sachs 5 (107) Morgan Stanley 8 (166) Bank of New York 4 (72) State Street - - Total 29 (598) Source: Barclays Research, Leverage Ratio, An Attack on Repo, August PFM Asset Management LLC 5

7 Impact of Liquidity Requirements Retail and operational wholesale deposits more valuable. High-quality, liquid assets are precious. Liquid reserves needed for undrawn commitments. Desire for longer-term funding. High-Quality Liquid Assets Total Net Cash Outflows > _ 100% Liquidity Crisis: Withdrawals of deposits, draws on letters of credit, etc PFM Asset Management LLC 6

8 Money Market Fund Reform

9 Background: Money Market Funds Stable net asset value (NAV) of $1.00 per share Registered and regulated by the Securities and Exchange Commission (SEC). Required to follow SEC Rule 2a-7: Weighted average maturity (WAM) Credit Quality Liquidity Diversification Stress testing Disclosures 2016 PFM Asset Management LLC 8

10 Money Market Fund Regulations Changed in 2010 Decreased maximum WAM from 90 to 60 days. Introduced a weighted average life (WAL) with a maximum of 120 days. Instituted daily and weekly liquidity requirements. Required periodic stress testing. Instituted stricter rules on securities with lower credit quality PFM Asset Management LLC 9

11 Money Market Fund Regulations Are Changing 2016 Changes Floating NAV for institutional prime money market funds Liquidity fees Redemption gates Depends on fund classification: Prime Government Institutional Retail 2016 PFM Asset Management LLC 10

12 Prime/Institutional Variable NAV 2016 changes will require that prime institutional money market funds operate with a floating, market value-based, NAV rounded to the fourth decimal place. A variation in the NAV of = $1,000 on a $10 million fund balance For illustrative purposes only. Net Asset Value Time 2016 PFM Asset Management LLC 11

13 Liquidity Fee Fee charged for a withdrawal under certain circumstances: If weekly assets fall below 30% of total assets, liquidity fees may be charged. If weekly assets fall below 10% of total assets, there is a default 1% liquidity fee on redemptions.* Fees can be lower or higher, up to a maximum of 2%.* Liquidity fees can be lifted once weekly liquid assets rise above 30% of total assets, and could be lifted at any time by the Board. *At Board s discretion PFM Asset Management LLC 12

14 Redemption Gates Suspension of redemptions If a fund s weekly liquid assets fall below 30% of its total assets, the money market fund s Board may temporarily suspend redemptions for up to 10 business days. Government money market funds are exempt from liquidity fees and redemption gates, but are permitted to institute them if disclosed PFM Asset Management LLC 13

15 Money Market Fund Regulations: Key Elements Prime Fund Retail Fund Constant NAV Redemption gates Liquidity fees Government Fund Constant NAV Optional redemption gates Optional liquidity fees Institutional Fund Variable NAV Redemption gates Liquidity fees Constant NAV Optional redemption gates Optional liquidity fees Effective October 14, PFM Asset Management LLC 14

16 Variable NAV Accounting Problems Activity Buy 10 million shares at $ per share Write check for $1 million Check clears 2 days later when share price is $ One week later, share price is $ Write check for $1 million Check clears 2 days later when share price is $ Transaction (Shares) Share Balance NAV Share Price Value of Shares +10,000,000 10,000, $ $10,000,000-10,000, $ $10,000,000-1,000,100 8,999, $ $8,999,000-8,999, $ $8,998,100-8,999, $ $8,998,100-1,000,400 7,999, $ $7,996, PFM Asset Management LLC 15

17 Constant NAV Accounting Activity Transaction (Shares) Share Balance NAV Share Price Value of Shares Buy 10 million shares at $ per share Write check for $1 million Check clears 2 days later when share price is $ One week later, share price is $ Write check for $1 million Check clears 2 days later when share price is $ ,000,000 10,000, $ $10,000,000-10,000, $ $10,000,000-1,000,000 9,000, $ $9,000,000-9,000, $ $9,000,000-9,000, $ $9,000,000-1,000,000 8,000, $ $8,000, PFM Asset Management LLC 16

18 Where Can You Invest Your Liquidity Now? Local Government Investment Pools (LGIPs) Money market fund rules will not apply to LGIPs Examples of LGIPs in California Local Agency Investment Fund (LAIF) Shares issued by a joint powers authority California Asset Management Program (CAMP) CalTrust County pool 2016 PFM Asset Management LLC 17

19 Why Weighted Average Maturity Matters Value of a $1.00 Investment Weighted Average Maturity (WAM) Money Market Fund Mutual Fund 30 Days 60 Days 180 Days 1 Year 1.5 Years 2 Years If Rates Rise 3% If Rates Rise 2% If Rates Rise 1% If Rates Rise 0.5% If Rates Unchanged If Rates Fall 0.5% If Rates Fall 1% If Rates Fall 2% If Rates Fall 3% NAV changes, share price changes, and dollar losses assume an immediate change in interest rates PFM Asset Management LLC 18

20 Stable vs. Variable NAV LGIPs that meet certain GASB criteria will be able to round their NAVs to the nearest penny. Impact of 0.5% Rate Increase Stable NAV LGIP/Gov MMF Variable NAV MMF Variable NAV Mutual Fund or LGIP WAM 60 days 60 days 1.5 years NAV Share price $ $ $ Loss on $10 million $0 $8,000 $75,000 Loss on $50 million $0 $40,000 $375,000 NAV changes, share price changes, and dollar losses assume an immediate change in interest rates. For illustrative and educational purposes only PFM Asset Management LLC 19

21 GASB Statement 79 Certain External Investment Pools and Pool Participants

22 GASB Statement No. 79 Issued December 23, 2015 Supersedes paragraphs in both GASB 31 and GASB 59 Parallels many aspects of the SEC s 2010 amendments to Rule 2a-7 Maturity Credit Quality Diversification Liquidity Shadow pricing Note requirements 2016 PFM Asset Management LLC 21

23 GASB Statement 72 Fair Value Measurement & Application

24 What Will This Statement Do Clarify how fair value should be measured for those assets (such as investments) and liabilities (such as derivatives that are in a liability position) that are currently required to be reported at fair value Expand the definition of investments subject to fair value Expand the disclosures in the footnotes of fair value This statement will not expand the use of fair value reporting to other liabilities (other than where currently required) Supersedes certain paragraphs in Statement 31 Accounting and Reporting for Certain Investments and for External Investment Pools For financial statements reporting periods beginning after June 15, PFM Asset Management LLC 23

25 Three Part Statement Measurement the act or process of assigning dollar amounts to elements in financial statements Application definition of what should be fair valued Disclosures presentation in the footnotes 2016 PFM Asset Management LLC 24

26 Fair Value Measurement Definition of fair value The price that would be received to sell as asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date Characteristics of fair value Exit price Market based Government s principal or most advantageous market 2016 PFM Asset Management LLC 25

27 Fair Value Measurement The price that would be received to sell as asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date Price Not adjusted for transaction costs Government s principal or most advantageous market Market participants Use assumptions that market participants would use to price asset or liability Measurement date Not necessarily financial statement date 2016 PFM Asset Management LLC 26

28 Measurement Valuation Techniques Market approach Uses prices Relevant information generated by market transactions involving identical or similar assets/liabilities Cost approach Amount required currently to replace the service capacity of an asset Income approach Converts expected future cash amounts into a single amount Present value Option-pricing models 2016 PFM Asset Management LLC 27

29 Measurement Risk adjustments Includes a risk premium or discount that market participants would demand as compensation Reflects an orderly transaction 2016 PFM Asset Management LLC 28

30 Change in Valuation Technique Change in accounting estimate New markets develop New information becomes available Information previously used is no longer available Valuation techniques improve Market conditions change 2016 PFM Asset Management LLC 29

31 Application of Fair Value Definition of an investment A security or other asset that a government holds primarily for the purpose of income or profit and with a present service capacity that is based solely on its ability to generate cash or to be sold to generate cash Service capacity Refers to a government s mission to provide services Held primarily for income or profit Acquired first and foremost for future income and profit 2016 PFM Asset Management LLC 30

32 Application of Fair Value An asset that is being held in order to further some part of the mission of the local government to provide services is NOT required to be reported at fair value Determination of whether the asset was acquired solely to generate cash and not for a program objective is determined at the time of acquisition A later change in the usage of the asset will not change the initial determination as to whether or not that asset will be reported at fair value 2016 PFM Asset Management LLC 31

33 Application of Fair Value Expanded definition of an investment now includes Real estate held for investment purposes Intangible assets held for investment purposes Land rights held for investment purposes (such as oil and gas rights) Natural resources held for investment purposes Alternative investments Stock warrants and stock rights Unit investment trusts and closed-end mutual funds 2016 PFM Asset Management LLC 32

34 Application of Fair Value Investments excluded Participating interest earning investment contracts (Stmt # 31) Investments in life insurance (Cash surrender value) Non-participating interest earning investment contracts (Stmt # 31) Unallocated insurance contracts (Stmt # 59) Synthetic guaranteed investment contracts that are fully benefit responsive (Stmt # 53) 2016 PFM Asset Management LLC 33

35 Hierarchy of Fair Value Inputs Level 1 quoted prices in active markets for identical assets or liabilities Level 2 quoted prices for similar assets or liabilities Quoted prices for identical or similar assets/liabilities in markets that are not active Other than quoted prices that are observable Level 3 unobservable inputs Inputs when actual market data is not available Assumptions and considerations that market participants use when pricing the asset 2016 PFM Asset Management LLC 34

36 Pricing Services Quoted prices provided by third parties Prices must be developed in accordance with this standard Government must determine if measurement is in accordance with GAAP Evaluate whether prices are developed using current information that reflects orderly transactions Valuation technique that reflects market participants assumptions 2016 PFM Asset Management LLC 35

37 Note Disclosures Organized by type or class of asset or liability Information for each class or type of asset / liability Fair value measurement at the end or reporting period For non-recurring fair value measurements, the reason for the measurement Level of hierarchy Description of valuation techniques For fair value measurements categorized within Level 3 Effect of those investments on investment income Other than those assets that have a calculated NAV 2016 PFM Asset Management LLC 36

38 Disclosure of Fair Value Inputs FYE Level 1 Level 2 Level 3 Debt securities U.S. Treasury $ 100 $ 20 $ 80 Corporate bonds Total debt securities Equity securites Financial services Health care Total equity securities Hedge fund investments Equity long/short Real estate fund Total hedge funds Total fair value $ 265 $ 105 $ 140 $ 20 * For illustrative purposes only PFM Asset Management LLC 37

39 Disclosure of Fair Value Inputs The City categorizes its fair value hierarchy established by generally accepted accounting principles. The hierarchy is based on the valuation inputs used to measure the fair value of an asset. Level 1 inputs are quoted prices in active markets for identical assets; Level 2 inputs are significant other observable inputs; Level 3 inputs are significant unobservable inputs. The City has the following recurring fair value measurements as of June 30, 20X1: U. S. Treasury securities of $45 million are valued using quoted market prices (Level1) Corporate bonds of $12 million are valued using matrix pricing (level 2 inputs). The City also has a nonrecurring fair value measurement as of June 30, 20X1, for a closed performing arts hall that will no longer be used by the government and therefore is considered impaired. The hall has been written down from $5.6 million to $3.4 million based on an appraisal of the proper (Level 3 inputs). Source Example 1 Appendix C of GASB Exposure Draft; Fair Value Measurement and Application May 5, PFM Asset Management LLC 38

40 Summary Bank reform is changing local government s ability to use deposits to manage liquidity Money market fund reform will change the type of funds available to institutions and how those funds provide interest and liquidity LGIPs and money market securities provide alternatives for liquidity no longer deposited with banks or invested in money market funds GASB 72 clarifies the use of fair value reporting and expands related disclosures 2016 PFM Asset Management LLC 39

41 Thank You Sarah Meacham, Director PFM Asset Management LLC

42 Disclaimers Any investment advice in this document is provided solely by PFM Asset Management LLC ( PFMAM ). PFMAM is an investment advisor registered under the Investment Advisers Act of PFM Advisors is a division of PFMAM. Public Financial Management Inc. is not providing and is not responsible for any investment advice herein. This material is based on information obtained from sources generally believed to be reliable and available to the public; however, PFMAM cannot guarantee its accuracy, completeness, or suitability. This material is for general information purposes only and is not intended to provide specific advice or a specific recommendation. All statements as to what will or may happen under certain circumstances are based on assumptions, some but not all of which are noted in the presentation. Assumptions may or may not be proven correct as actual events occur, and results may depend on events outside of your or our control. Changes in assumptions may have a material effect on results. Past performance does not necessarily reflect and is not a guaranty of future results. The information contained in this presentation is not an offer to purchase or sell any securities PFM Asset Management LLC