Japanese banks are using letter-of-credit expirations to reassess their exposure to municipal issuers, shed lower-quality debt, and increase fees.

Sanwa Bank Ltd. last week drew the attention of the municipal markets when it declined to renew a letter of credit for the Philadelphia Water Department and offered only a six-month extension to Enid, Okla.

While some market participants wondered whether the actions signaled a retreat from the market, enhancement providers throughout the banking industry ecategorically disagreed.

"I don't think it's going to be the start of any trend," said Lisa Pent, assistant vice president at Fuji Bank Ltd., the number one letter-of-credit provider. "It's just that there's a lot written about the U.S.A. in [Japanese] papers. When something's getting bad press, they know about it. A lot of [banks] are trying to get out of their current exposures to health care."

The most likely result is for the industry to gradually shrink exposure to any issuers whose finances are deemed suspect.

"There's more of a distinction between the better credits and the lesser ones," said Barbara H. Delisle, a vice president at National Westminster Bank. "A lot of banks got involved thinking that municipalities don't default, and all of the banks have improved their credit skills immensely."

At the beginngin of 1991, the Japanese banks began a four-year period when an enormous number of tax-exempt deals come up for renewal. From 1984 through 1987 -- when letters of credit were routinely seven years long -- the top five Japanese credit enhancement banks collectively backed an annual average of more than $6 billion, according to Securities Data Co.

The five banks are Fuji Bank, Sumitomo Bank Ltd., Sanwa Bank, Mitsubishi Bank Ltd., and Dai-Ichi Kangyo Bank Ltd. The data do not include participations. Representative of the banks without exception deny they are trying to pull up stakes, as some municipal officials have feared. On the contrary, a public finance worker at one of the top five Japanese banks said, "We're trying to expand and do as much business as we can."

For the overall market, Moody's Investors Service estimates that in 1992 alone, $8 billion to $10 billion of municipal letters of credit and standby repurchase agreements are scheduled to expire. About 275 separate deals will come due, with Fuji facing 30 deals, Mitsubishi reviewing 25, Dai-Ichi Kangyo and Sanwa each at 15 deals, and both Citibank and Union Bank of Switzerland examining 12.

Expirations provide banks with the opportunity to raise premiums or, if an issuer's fortunes have taken a turn for the worse, to remove the exposure altogether. For the most part, newly gun-shy Japanese banks drop municipal exposure by finding another bank to replace the existing letter of credit with one of their own.

"Philadelphia Water was a news issue [because] no other bank was willing to step up," one banker said.

Sanwa attributed its stance toward Philadelphia Water to a participant bank -- identified by other sources as Mitsui Tokyo Kobe Ltd. -- declining to renew its portion of the original deal, underscoring the interdependence of the syndicate members behind each large letter of credit.

"Sanwa was prepared to go through with an extension that had been requested from us," a spokesman for Sanwa said. "The main problem was that we couldn't get 100% cooperation from the participants."

Until the Sanwa/Philadelphia row, the Japanese banks presented a unified face to the market. In fact, Japanese public finance officials often exchange pricing and deal-structuring information. One possible outcome is that behind-the-scenes disarray could hamper traditional providers, or "fronting" banks, from mustering enough participant support to do the larger borrowins, several sources said.

Participating banks on the vast number of deals enhanced in the mid-1980s included a group of little-known Japanese banks whose actual presence in the U.S. is minimal. These institutions routinely accepted exposure to municipal debt with little or no analysis, relying on the fronting bank's judgment. Hokkuku Bank, Bank of Yokohoma, and Juroku Bank are a few examples.

Internally, Japanese banks are also wrestling with risk-weighted capital requirements imposed by the Bank of International Settlements. The rules penalize banks with exposure to credits deemed risky -- such as hospitals or pollution-control facilities -- and reward general obligation exposure. The main result has been to constrict asset growth.

Several public finance bankers said the largest providers of letters of credit are likely to use the flood of renewals to "clean up" portfolios and fine-tune exposures for compliance with the Bank for International Settlements accords. Accordingly, banks eyeing certain large new deals will seek replacements, rather than renewals, to make room for the new borrowing.

Another aspect affecting the largest providers -- most of which are Japanese -- is the daunting task of monitoring the renewals. Fuji, for example, has a portfolio of $12 billion to watch over. "You need a lot of people to monitor that, let alone to write new business," one banker noted.

Municipal issuers said the Japanese banks are not retreating so much as seeking better returns. When the tax-exempt letter-of-credit market was in the banks' thrall seven years ago, premium rates were incredibly low. And fees reached a low-water mark of eight basis points as recently as 1989, sources said.

For dramatic counterpoint, fiscally troubled New York City today will sell $985 million of general obligation bonds, and Fuji Bank, Industrial Bank of Japan, and Sumitomo -- along with Morgan Guaranty Trust Company of New York -- are backing $200 million of the deal for about 50 basis points, according to the city comptroller's office.

"We have not seen [the Japanese] pulling away from the LOC market," said Edward M. Murphy, executive director of Massachusetts Health and Education financing Authority. "But we have seen the prices go up, and they're not going out as long as they used to."

Lee F. Jackson, the collector treasurer of Boston, said Sanwa and other Japanese banks are tightening their belts, but certainty not withdrawing. "Our dealings with Sanwa suggested to me that they are still interested in our business and would in fact like to do more business," Mr. Jackson said. "It wouldn't surprise me if they either raise fees or ... negotiate tighter covenants on credits they perceive to be marginal."

One of the major ways the banks are limiting exposures is by writing enhancements with shorter durations. Five-year letters already are commonplace, and some banks have been exploring still shorter commitments. The idea, participants said, is to get more frequent opportunities to alter the commitment or decline altogether.

"LOCs are much shorter in length," said William deSante, managing director at Moody's Investors Service. Because of downgrades and bank-capital requirements, "There's been a lot of pressure on the LOC market over this last year," he said. "Volume is way down, and banks are looking with greater scrutiny at the risks they undertake."

A common misperception with letter-of-credit renewals is that bondholders are at risk should a bank back out. In fact, banks must make good on the debt and then seek reimbursement from the issuer it just abandoned, which could be a costly prospect.

Consequently, the largest liability incurred by not renewing letters of credit rests in the public eye. Japanese banks will lose face if the municipal market perceives a wavering commitment.

"It's not cost-effective, and you get terrible publicity," said one official with a Japanese bank who asked not to be identified. "There are a lot of municipalities who are going to wonder why Sanwa is forcing the Philadelphia Water Department" into a bind.

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