Industry Publications

Summer 2005

Adam Goldstein, VP & Director of Sales & Marketing
Federal Home Loan Bank of New York

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

This article appeared in the:
IBANYS - Community Bank Notes

Since liquidity is a key strategic issue for financial institutions, having available collateral is a crucial element for tapping additional resources. Often, securities in your investment portfolio are used to collateralize municipal deposits. While this may be a valid method of managing your balance sheet, it has a downside: it may curtail your liquidity position and create operational headaches. In the past, banks did not have another way to collateralize municipal deposits, but now under New York law, commercial banks, and savings and loans or savings banks that are approved to have branches in New York State Banking Development Districts, may utilize a Federal Home Loan Bank (HLB) Letter of Credit (L/C) as eligible collateral. {See inset for New York General Municipal Law, section 10(3)(c), as amended in 2003, and New Jersey Administrative Code.}

The New York General Municipal Law, section 10(3)(c), as amended in 2003:
“In lieu of or in addition to the deposit of eligible securities, the officers making a deposit may in the case of an Irrevocable Letter of Credit issued in favor of the local government by a Federal Home Loan Bank whose commercial paper and other unsecured short-term debt obligations are rated in the highest rating category by at least one nationally recognized statistical rating organization, accept such Letter of Credit payable to such local government as security for the payment of one hundred percent of the aggregate amount of public deposits from such officers and the agreed upon interest, if any.”

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 L/C is an Aaa-rated credit instrument used to ensure payments to a third-party beneficiary in the event of a default of performance. The HLB issues two types of L/Cs, 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. Both types are widely accepted, low-cost, and easy to use, with no capital stock purchase required. They can be used to effectively collateralize your municipal deposits.

While municipal deposits are valuable for depository institutions, they require heavy collateral backing. When a municipal deposit is collateralized with securities, additional operational expenses are added since the security needs to be monitored and tracked in order to ensure that its value does not fluctuate below the original amount deposited. Unlike securities, the value of an L/C does not change; therefore, it reduces your operational expense by eliminating the need to match securities and monitor margin calls.

In addition, by using an HLB L/C in lieu of securities as collateral when competing for municipal deposits, you can free up your securities portfolio for other pledging purposes. The use of an L/C also enables your institution to reinvest lower yielding securities, such as treasuries (which are sometimes required by the municipality), into higher yielding securities. The freeing up of these securities may also allow you to invest in the form of loans in your communities. The resulting profitability should easily offset the cost of the L/C (1/8 of 1% per annum).

HLB L/Cs are recognized by both our members and municipalities as a very attractive way to collateralize municipal deposits. Peter Gioffe, Vice President/Cashier of member lender Delaware National Bank of Delhi, commented, “The utilization of FHLB's Municipal Letters of Credit has allowed us to maintain the proper level of collateral on our municipal depositors with ease and efficiency.” Municipalities especially 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.

An HLB L/C may also be a helpful tool for everyday banking purposes, such as facilitating interest-rate swap transactions with third parties, beneficiaries’ draws of interest payments from bond issues, and the purchase of or the commitment to purchase mortgage loans, and promoting housing development through the use of bonds. Other benefits include the provision of credit enhancements for collateral subordinated obligations or other MBS securities, as well as credit support in the sale of whole mortgage loan portfolios.

In the past, the HLB has sponsored breakfast workshops for our members where they invited their municipal depositors to a location of their choice. In these workshops, we discuss the uses of an L/C, the history and cooperative nature of the Home Loan Bank System, and how we issue L/Cs. We still continue this practice upon a member’s request.

If you or your municipalities would like additional information on the HLB’s L/C, contact Adam Goldstein, Vice President, Director of Sales & Marketing, at (212) 441-6703.

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