Collateralize Municipal Deposits with Aaa-Rated Letters
of Credit
from the Federal Home Loan Bank of New York
Adam Goldstein, VP & Director of Sales & Marketing |
Summer 2005 |
This article appeared in the Association of Towns of the State of New York’s Talk of the Towns and the NY State GFOA’s 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. Now, under New York State 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.)
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 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. Peter Gioffe, Vice President/Cashier of member lender Delaware National Bank of Delhi New York, commented, “The utilization of HLB's Municipal Letters of Credit has allowed us to maintain the proper level of collateral on our municipal depositors with ease and efficiency.” This method of collateralization can be more efficient because collateralizing with securities can be often costly for member institutions due to the operational expense of tracking and monitoring the security. 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.
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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