Low Rates Shrink Government Income
Low short-term interest rates continue to erode the investment income of state and local governments.
While interest on bank deposits and other short-term investments contribute a small percentage of municipal revenues, the squeeze on investment income is yet another pressure at a time when most sources of state and local government revenue are under significant stress.
Municipalities that have filed financial statements for fiscal 2010 show a drastic decline in investment earnings. According to Merritt Research, the median city in 2010 reported investment income of $593,000, down 28% from fiscal 2009 and 72% from fiscal 2008. The median school district’s investment earnings tumbled 72% from 2009 and 88% from 2008.
It should be noted that the numbers are incomplete. Only a minority of issuers have filed their comprehensive annual financial reports for fiscal 2010, which for most governments ended in June. For instance, 131 cities have filed their reports, out of a pool of about 700 that are expected to file eventually.
Richard Ciccarone, director of municipal research at McDonnell Investment Management, who is also president of Merritt, said initial filings are usually predictive of the trend. He likened it to using the initial returns from elections, which are not definitive but usually point in the right direction.
“You can see the number is already showing up to be a huge downturn,” Ciccarone said of the investment income figures. “That has been a huge hit, and not gotten much attention.”
The decline is broadly attributable to two things: municipalities have lower cash balances because urgent spending needs have coincided with a sharp drop in tax receipts the past few years, and the income that governments can wring out of their cash has shriveled because of low interest rates.
Like just about any entity with imperfectly matched cash inflows and outflows, municipalities often find themselves holding cash before they need to use it.
A government may raise proceeds from a bond sale for a capital project, and spend that money over a schedule of months or years as the project is completed. Or it may collect property taxes annually to finance a budget evenly over the course of the year.
Municipalities are rarely looking to take risks with such money — with Orange County, Calif., a notable exception in the 1990s.
Instead, governments park this money in super-safe places like bank accounts, money market funds, guaranteed investment contracts with a bank or insurance company, short-term Treasuries, or other iron-clad instruments generally considered equivalent to cash.
Until a few years ago, even short-term low-risk cash-equivalent interest rates provided a meaningful amount of revenue. According to the Census Bureau, state and local governments in 2008 collected $93.4 billion in interest — 3.5% of their total revenue.
The evisceration of investment earnings has its roots in the financial crisis, which sparked a flight to quality and prompted the Federal Reserve to pin short-term interest rates to the floor.
Fed chairman Ben Bernanke slashed his target for the federal funds rate to a range of zero to 0.25% in December 2008, and has unwaveringly held it there since. By comparison, the target was 5.25% in August 2007, when the collapse of two Bear Stearns hedge funds unofficially inaugurated the credit crisis.
The Fed’s commitment to minimal borrowing costs has exerted a gravitational pull on short-term interest rates of all stripes, from Treasury bills and money market funds to GICs and bank deposits.
The 90-day Treasury yield, for instance, is barely more than 0.1%, compared with more than 4% in August 2007. A six-month bank deposit yields about 0.4%, according to Bloomberg LP, whereas in August 2007 it yielded 5.6%. Money market fund returns have been measured in single-digit basis points for more than a year. These rates have squeezes all kinds of savers, but few categories of investors are as heavily exposed to short-term savings rates as municipalities.
At the end of the third quarter, according to the Fed, state and local governments held $612.2 billion in cash, bank deposits, money market funds, and repurchase agreements — almost 23% of their assets.
If one includes Treasury securities as cash, the total swells to more than $1.1 trillion, or 42% of municipal assets.
By comparison, nonfinancial companies hold 14% of their assets in cash, according to the Fed. Commercial banks hold 6.2%, property and casualty insurers hold 5%, and life insurers hold 1.6%.
When short-term interest rates were higher several years ago, the income generated on cash became a more significant source of revenue for many state and local governments.
In 2007, 3.7% of the median city’s revenue came from investing. Last year, less than 1% came from investment income.
The median school district derived nearly 2% of its revenue from investment income in 2007. Last year, investment income contributed 0.22% of the median district’s revenue.
It is not hard to find examples of municipalities facing this problem. The Los Angeles Unified School District, which is the biggest school system in the country, reported a 22% decline in unrestricted investment earnings in fiscal 2010.
The district wrung $58.3 million from its $7 billion in investments, most of which are held in the Los Angeles County Pooled Surplus Investment Fund and mature in less than a year. The return implies a yield of about 0.8%.
The district’s investment income last year was barely a third of the return two years earlier.
Portland, Ore., reported a 67% plunge in investment income last year.
San Francisco’s interest and investment income from governmental activities shrank 21%, to $27.9 million last year. The average interest rate collected on the city’s investments contracted to 1.38%, from 2.56%.
In its CAFR, the city said it decided to lengthen the maturity of some of its investments — mostly Treasuries and other government securities — in order to enhance yield.
Another place where the impact of low interest rates can be found is in the returns on university endowments.
The average college or university endowment returned 11.9% in fiscal 2010, according to the National Association of College and University Business Officers. Interestingly, big endowments performed better than small endowments.
The average endowment bigger than $1 billion returned 12.2%, while the average endowment smaller than $25 million returned 11.6%.
While it was hardly the only factor separating these classes of endowments, one distinction was that smaller endowments allocated twice as much of their assets to cash as big endowments — 8% compared with 4%.