First of two parts

Given the polarized debate spurred by the budget crises of state and local governments — Are widespread defaults imminent? Are the doomsayers exaggerating? — it would be easy for bankers to fear overreacting.

But business as usual, in a market where banks have been complacent about their seemingly safe municipal bond holdings, would be big mistake, experts say.

"Many banks' attitude toward muni holdings is 'buy and forget,' and that doesn't work in the current environment," said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott. "It takes a little bit of legwork and it takes a more active investment."

And the issue is more than investment. Banks are tied to municipalities as underwriters and as providers of guarantees. Banks also offer deposit services, direct loans and other traditional banking products to municipalities. Such relationships are critical at a time when banks are not lending heavily and need as much noninterest income as possible and reliable, profitable places to invest their money.

American Banker asked market strategists, bankers and analysts to dissect both the risks and opportunities municipalities present. In this story, part 1 of 2, they warn about the need to reassess portfolios and of the threat to underwriting fees. Part 2 will offer a detailed discussion on the future of lending and other banking services provided to municipalities.

End of 'Complacency'?
Above all, those interviewed for this story called for a proper balance of perspective and action.

On the investment side, the consensus among analysts is that banks are fairly safe from major losses stemming from any further distress in the market, as municipal bonds make up a relatively small portion of their investment holdings.

However, experts say banks shouldn't completely discount the recent hysteria. If anything, the last few months should be reason for banks to take a closer look at their municipal bond holdings.

Commercial banks had about $229.1 billion, or 1.6% of their total assets, tied up in municipal securities as of the end of the third quarter, according to the Federal Reserve. That's less than 10% of the roughly $3 trillion municipal bond market. By comparison, banks owned more corporate and foreign bonds, about $904 billion, and much more of mortgage securities backed by agencies and government-sponsored enterprises, about $1.3 trillion, or 9% of their assets, at the end of the period.

Among the top banking companies, Citigroup Inc. is the largest holder of municipal securities, with about $15.3 billion of the bonds on its books, according to Highline Financial LLC, which is owned by Thomson Reuters. Wells Fargo & Co., U.S. Bancorp, State Street Corp. and JPMorgan Chase & Co. round out the top five in holdings among banks.

The municipal bond market is a relatively small slice of the bond market. Case in point: At the end of the third quarter there was about $11.4 trillion of corporate and foreign bonds outstanding and about $9 trillion of Treasury bonds, according to the Fed. By comparison, there was about $14 trillion of outstanding mortgage debt at Sept. 30.

Yet because of their steady, tax-free yield and traditionally low default rate, municipal bonds have long been seen as a safe place to park cash for an extended period of time. As such, the market is dominated by retail investors.

Detailed, up-to-date financial information on municipalities is scarce, since local governments aren't required by the Securities and Exchange Commission to provide any. So, investors — including banks — have largely relied on credit ratings to help them make investing decisions and bond insurance to be a backstop in the case of a default.

"You had a low default rate, relatively high ratings and bond insurance," said Richard Ciccarone, chief research officer at McDonnell Investment Management, a fixed-income asset manager in Oak Brook, Ill. "The combination gave them a sense of complacency."

The Turning Point
In the fourth quarter of last year, though, investors began pulling large amounts of money out of municipal bond funds, the result of a confluence of many factors. Bonds in general sold off as an improving economy lured investors into riskier assets, like stocks, putting upward pressure on Treasury yields.

A report from an influential banking analyst warning about a dire shortfall in municipal budgets further spooked investors, whose bond holdings were declining in value.

Meredith Whitney, a former Oppenheimer & Co. analyst who now runs her own firm, issued a report in September saying "the fiscal challenges facing states could be the next systemic risk within the U.S. financial markets."

Whitney, who made a name for herself in 2007 when she predicted that Citigroup would need to cut its dividend, stirred more fear when she appeared on an episode of "60 Minutes" in December and predicted hundreds of billions worth of defaults.

Her prediction jolted this traditionally sleepy area of finance. A torrent of cash fled municipal bond funds in the fourth quarter and the sell-off continued in January, culminating in a record $4 billion of outflows during the week that ended Jan. 19. Investors have continued to shed their municipal bond holdings, but the panic-driven selling has subsided somewhat in the past few weeks.

Many municipal bond analysts have since criticized Whitney, calling her report flawed and incendiary.

George Friedlander, who oversees municipal research at Citigroup Investment Research, called Whitney's report a "scare story."

"What we are not anticipating is the type of large-scale credit crisis forecast by certain individuals writing from a perch outside the municipal bond sector, including a recent report on '60 Minutes,' which suggested the likelihood of widespread defaults on local municipal credits over the near term," he wrote in a report in January.

Ciccarone was a bit more decorous in his response to the report.

"We take it as useful information, but she's talking about things that a lot of experts in the muni industry have been talking about for awhile," he said. "There's a modicum of truth there, nobody's denying. But the call for the surge in defaults in a single year [has] to be put in perspective. Defaults don't normally happen to munis. … That risk is mitigated even more so if you have a [gross domestic product] that is growing at 2% to 2.5%."

If anything, Whitney's report has shed light on an area that deserves more scrutiny by banks, experts said.

LeBas said some of his bank clients are taking "a second look" at their holdings.

"If an issuer hasn't provided information for a number of years," that "is a reason to say goodbye to that holding," he said.

Double-Down Debate
Some banks are taking advantage of the market volatility and have been increasing their holdings, LeBas said.

"The primary benefit of a municipal bond is its tax exemption, and it's very challenging to match the income from even a triple-A rated bond in another market," he said. "Mortgage-backed securities, you're probably looking at a 3%-3.5% yield. That's what some munis might hold, too, but it's tax-exempt. That's a huge advantage. I would argue that many of the smart-money banks are taking a contrary position and actually adding to muni holdings as panic rises. They see value. Larger institutions find those holdings worth the risk."

Not everyone, however, sees the municipal bond market as a good opportunity. Richard Bove, a banking analyst at Rochdale Securities Inc., said there's no need for banks to significantly increase their municipal bond holdings, because they have other ways to reduce their tax obligations.

"If you have a sizable tax-loss carry-forward, which all of these big banks have, it makes no sense to buy municipal bonds," he said. "You buy municipal bonds because you get a high tax-free yield. If you've got a tax loss, you're not paying taxes anyway. And if you're not paying taxes you don't buy municipal bonds, because the yields are not attractive."

This Side Hurts
Banks could potentially feel more pain on the underwriting side of the business, since municipal bond issuance is expected to drop this year. Municipalities rely on banks to underwrite their bond offerings, and pay them fees to do so. Last year, municipalities issued a record $430.1 billion of long-term debt, a nearly 6% increase from 2009.

Citigroup Investment Research has forecast a roughly 20% drop in issuance in 2011, to $350 billion. A dip in issuance could cut into the fees banks earn on underwriting.

Bank of America Corp.'s Merrill Lynch underwrote $59.9 billion of deals in 2010, the most of any banking company, according to Thomson Reuters. Citigroup was close behind, underwriting $58.9 billion of issues. About 75% of the underwriting market is controlled by just 10 banks.

Representatives from Bank of America and Citigroup declined to comment for this story.

Lawmakers also have grown concerned. On Feb. 9 the House Committee on Oversight and Government Reform held a hearing to discuss a possible municipal debt crisis and whether to grant states the ability to declare bankruptcy. (Some cities, towns and school districts are permitted by law to file for bankruptcy, but states cannot.)

One expert witness urged lawmakers to be cautious in their approach to the fiscal problems hurting state governments since banks are closely intertwined.

"If Congress wants to raise the prospect that a state could someday default on its debt, it would have to raise the prospect that a large bank or money market fund, too, could suffer large losses as a result of that default," said Nicole Gelinas, Searle Freedom Trust Fellow at the Manhattan Institute for Policy Research.

"Creating a process for a state or multiple states to default on debt obligations without first ensuring that a large bank can go through the bankruptcy process could create economic chaos, forcing Congress, in the end, to save the state or the bank," she said. "This is hardly a good choice."

Coming Next: Is more lending to municipalities a good idea?

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