Banks embrace municipal bonds as customers seek shelter.

Gary Lazarini had just about given up on the municipal bond market after the Tax Reform Act of 1986 pushed banks away from tax-free debt. But then interest rates began to fall.

"It was a business we had just about done away with, "said Lazarini, president of Commerce Investment Corp., a subsidiary of National Bank of Commerce in Tennessee. "It took 1992 for banks to start to get back into the business, and we feel they are going to be more and more interested in staying in that business."

Last year marked a record for municipal bond volume that 1993 is expected to smash easily. From the perspective of the banks. the volume is generating badly needed fee income for underwriting debt and tax-free investments for their customers.

While banks have historically been players in the municipal underwriting and sales business, as many as 250 banks - from Bank of Oklahoma to Bank of America - view municipals as a profit center with long-term potential.

"We've always been in that business in a big way," said Ralph Horn, president of First Tennessee National Bank of Memphis, a $9 billion-asset company. "If you go back 20 years, munis made up maybe 80% of our [securities] business, but since 1986, it has been more in the area of 10%."

Many bank executives interviewed agreed, but said they expect municipals to be increasingly important as their customers seek shelter from the higher personal income tax rates that took effect with the passage of the Clinton tax package last month.

"We're always trying to introduce new products to our customers, and municipal bonds certainly fit into that," said Robert Drysdale, president of PNC Securities Corp. The company is an affiliate of PNC Bank Corp. of Pittsburgh, which has $52.5 billion of assets.

While many banks are considering entering the municipal securities business, experts say that long-term players will either develop a niche or take a full-service approach by offering sales, trading, and underwriting in direct competition with brokerages.

"I see more banks getting involved in this business," said Drysdale, a Wall Street veteran. "But I see a lot of banks thrashing around in the securities business and going after the hot product. Today, that might be mutual funds."

There is a perceived rash of metooism in bank investment products, but scores of banks have long developed their own place in the municipal market.

St. Louis-based Boatmen's Banc-shares has had a municipal operation since its founding. Bill Darmstaedter, vice president and manager of public finance, said his department focuses on advising local governments and on underwriting smaller issues for cities. schools, or counties in places where it has a banking presence.

"We're not looking much at those $50 million revenue bond issues." Darmstaedter said. "We're more interested in the $5 million issue from a small city."

There is a good reason that small issues appeal to banks. The federal tax code gives banks the right to deduct up to 80% of the cost of owning and carrying municipals if the government agency issues less than $10 million in debt annually. Such bonds are known as bank-qualified debt.

In recent years, bank-qualified bonds have accounted for up to 7.7% of the municipal market. Through Aug. 30, such debt accounted for $10.9 billion, or 5.7%, of the $193.9 billion in tax-free bonds sold so far this year, according to Securities Data Co.

Banks are not the only institutions that underwrite such bonds. but many specialize in the market. So far this year, Harris Trust and Savings Bank ranks as the fifth-largest underwriter of bank-qualified debt, with 65 issues totaling $265 million. Not far behind, in 13th position, is First Tennessee, with $211 million in such deals.

Market watchers say banks are this year's most aggressive buyers of bank-qualified bonds. Executives at Bank of Oklahoma, a subsidiary of BOK Financial Corp. of Tulsa, say the combination of a compressed yield curve and cleaned up balance sheets has left bank-qualified bonds in short supply.

"Our correspondent banks have a real appetite for the bonds," said Brett Dean, senior vice president at Bank of Oklahoma. "It's a very profitable business."

If lobbyists for the banking and securities industries have their way, the market for bank-qualified bonds will only grow. Trade groups have failed again this year to persuade congressional tax writers to expand the bank-qualified privilege to bonds issued by governments that sell up to $25 million a year in debt.

Some proponents estimate that a $25 million ceiling could triple the potential market for these tax-free securities.

Jim McLaughlin, director of trust and securities at the American Bankers Association, said annual proposals to expand the reach of bank-qualified bonds have been lost in a crush of tax proposals.

"I'm not sure there is opposition as much as there is lethargy," McLaughlin said.

Many believe the change is inevitable and say it would only encourage more banks to develop municipal bonds as a line of business. Still, few believe Wall Street and regional brokerages have much to fear from banks as underwriters.

Overall, banks or their securities subsidiaries have just a sliver of the market.

For instance, First Chicago Capital Markets is the top-ranking bank underwriter of municipal bonds, with a 1993 volume of $2.5 billion. That makes it the 14th-ranked underwriter, but its volume is barely one-tenth that handled by market-dominating Merrill Lynch & Co.

Gerald P. McBride, executive vice president of tax-exempts at Prudential Securities Inc. and a spokesman for the Public Securities Association, an industry trade group, said banks will always be municipal market players.

But does he lose sleep over the prospect of stronger bank competitors? "Not a wink," McBride said.

He is not alone.

Perrin Long, a veteran brokerage analyst at First of Michigan in Detroit, said there should be plenty of business to go around in the 1990s.

"Historically, banks have always been a player because they have been close to the municipalities whose bonds they underwrite," Long said. "But they don't want to be kingpins. Sure, they'll get more opportunity, but it will not have a major impact."

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