Industry Publications

Fall 2005

Adam Goldstein, VP & Director of Sales & Marketing

Collateralize Municipal Deposits with a Aaa-Rated Letter of Credit from the Federal Home Loan Bank of New York

This article appeared in the:
New Jersey GFOA - Report Newsletter

When depositing a significant amount of money into a financial institution, municipalities require their municipal deposits to be secured. Usually, a financial institution will post a number of its securities to collateralize the municipal deposit. While this is a sufficient form of collateral, it can be burdensome for both the municipality and its financial institution when a municipality needs to liquidate the security. With securities pledged as collateral, a default, albeit unlikely, will trigger a liquidation process. This process may hinder the promptness of the payout to the municipality, as the securities need to be sold in the open market.

Fortunately, there is an alternate way to secure municipal deposits in a safe and legal manner that is operationally efficient for all parties, providing municipalities with a prompt payout for the full dollar amount of the deposit in the unlikely event of a draw. Under New Jersey Administrative Code, member commercial banks, and savings and loans or savings banks may utilize a Federal Home Loan Bank (“HLB”) Letter of Credit (“L/C”) as eligible collateral.

The New Jersey Administrative Code:
“In addition to obligations otherwise authorized in N.J.S.A. 17:9-41, eligible collateral shall also include irrevocable stand-by letters of credit issued by the Federal Home Loan Bank of New York. The Commissioner shall review and approve the form of all such letters of credit proposed by a public depository as eligible collateral under this section. Further, the original letter of credit shall be held by the Commissioner.” N.J.A.C. 3:1-4.13 - Eligible Collateral.

The HLB’s L/C is a credit instrument guaranteeing payment on behalf of its customer (HLB’s member) to a beneficiary (the municipality), for a stated period of time and under certain conditions. The institution can use an L/C in lieu of securities as collateral. The bank can obtain an L/C from a wholesale lender, such as the HLB. The HLB can issue an L/C on behalf of a member bank, substituting the credit standing and capital market access of the HLB for that of the member. On the day of the transaction, the municipality receives a one page L/C via fax, followed by the original by overnight mail. In the unlikely event that the municipality’s bank defaults on its commitment, the municipality can submit the draw request to the HLB for prompt payment.

The HLB issues two types of L/Cs on behalf of its members to effectively collateralize municipal deposits: an Irrevocable Standby L/C and an Irrevocable Direct Pay L/C. The Irrevocable Standby L/C provides that the HLB will pay a draw request to the beneficiary, when the beneficiary certifies there has been non-performance with respect to an underlying transaction. The Irrevocable Direct Pay L/C permits the beneficiary to look directly to the HLB for satisfaction of the member’s obligation. Since the HLB’s L/Cs are legally accepted as eligible collateral, holding Moody’s Aaa credit rating, both types are widely accepted.

HLB L/Cs are recognized by both its members and municipalities as a very attractive way to collateralize municipal deposits. This method of collateralization can be more efficient for member institutions because collateralizing with securities can be often costly due to the operational expense of tracking and monitoring the security. Municipalities find HLB L/Cs appealing because, unlike securities, the value of an L/C remains constant and does not change with market fluctuations. Accepting L/Cs as collateral poses no additional cost to the municipal depositor, since the HLB member institution pays for the L/C.

If you would like additional information on the HLB System, L/Cs, and the benefits they offer you, contact Adam Goldstein, Vice President, Director of Sales & Marketing, Federal Home Loan Bank of New York, at (212) 441-6703.

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