U.S. Banks Risk ‘Untold Problem’ as Muni Debt Swells
By Dakin Campbell
(Bloomberg) — Citigroup Inc., State Street Corp. and U.S. Bancorp are among U.S. banks whose municipal bond holdings have reached a 25-year high just as state budget deficits swell to $140 billion, the most since the start of the recession.
Commercial lenders added more than $84 billion to their holdings since 2003, according to the Federal Reserve, pushing total investments to $216.2 billion at the end of the first quarter. Bank regulators and ratings companies are ramping up scrutiny of banks most at risk of being forced to raise more capital should debt prices slide.
“There is a huge untold problem here,” said Walter J. Mix III, a former commissioner of the California Department of Financial Institutions who closed 30 banks during the last banking crisis in the 1990s. “The economics lead to the conclusion that there will be downward pressure on these bonds.”
At Cullen/Frost Bankers Inc., the biggest Texas lender, holdings of municipal debt exceeded Tier 1 capital, a key measure of a bank’s ability to absorb losses, by $491 million at the end of the first quarter, data compiled by Bloomberg show. For State Street, based in Boston, the holdings make up 50 percent of Tier 1 capital. U.S. Bancorp, the Minneapolis lender, has a ratio of 28 percent. It’s 11 percent at Citigroup, the data show.
Municipal Bond Yields
Default speculation and a move by investors to the safest securities drove municipal bond yields to a 13-month high relative to U.S. Treasuries in the first half of the year. Now, the Federal Deposit Insurance Corp. has asked analysts to look into the issue, according to spokeswoman Michele Heller.
The 9.5 percent U.S. unemployment rate and slump in property prices have slashed local governments’ ability to pay bills. Billionaire investor Warren Buffett, speaking at a June 2 hearing of the Financial Crisis Inquiry Commission in New York, predicted a “terrible problem” for municipal bonds. Buffett has said a U.S. state facing default may need a federal rescue.
Analysts and investors remain divided about the level of risk. Lenders hold just 8 percent of the $2.8 trillion state and local government debt market, and municipal bonds are only about 2 percent of total bank assets, according to the Fed.
‘Train Wreck’
“The open issue is whether it’s a slowly emerging train wreck,” said Jeff Davis, an analyst at Guggenheim Securities LLC, a unit of Guggenheim Partners LLC, whose executive chairman is former Bear Stearns Cos. Chief Executive Officer Alan D. Schwartz. “It’s hard to paint all general obligation and all revenue bonds with the same brush. The portfolios won’t go to zero.”
Municipal defaults are a slender risk, according to Moody’s Investors Service, which said in a February report that the investment-grade rate during the past four decades was 0.03 percent, compared with 0.97 percent for similar corporate issues. Investors eventually recoup an average of 67 cents on the dollar for defaulted municipal bonds.
While the historical default-rate risk for municipal debt is below corporate obligations, sudden declines in prices have already created losses at some banks.
Citigroup had an unrealized loss of $1.8 billion in the third quarter of 2008, when the municipal market sank 3.8 percent, the biggest quarterly decline since 1994, company filings and Bank of America Merrill Indexes show. The loss was deducted from the firm’s equity.
Citigroup
“Citi’s exposure to the municipal market is of the highest quality,” Danielle Romero-Apsilos, a spokeswoman for the New York-based firm, said in a statement. “We conduct rigorous stress tests under a variety of scenarios and are comfortable with our position.”
Citigroup had the largest municipal holdings among the biggest banks as of March 31, with $13.4 billion of state and local government bonds, according to FDIC call reports. That’s down from $13.8 billion at the end of last year. Bank of America Corp. held $8.5 billion, Wells Fargo & Co. owned $7.6 billion and JPMorgan Chase & Co. held $4.5 billion. Each accounted for less than 8 percent of Tier 1 capital, according to the FDIC.
Bank of America, based in Charlotte, North Carolina, has made “significant progress” boosting capital and reducing risk-weighted assets, spokesman Jerry Dubrowski said. The lender trimmed its municipal investments by more than $800 million in the first quarter. JPMorgan spokeswoman Jennifer Zuccarelli didn’t return a call for comment.
Wells Fargo
Wells Fargo, based in San Francisco, boosted its municipal holdings by more than $2 billion in the first quarter, data compiled by Bloomberg show. The investments are in municipalities “we know very well,” Chief Financial Officer Howard Atkins said on May 13.
State Street, the second-largest independent custody bank, owned $6.2 billion of state and local government debt at the end of March, the data show. State Street is “very comfortable” with its portfolio and has had no material credit issues, spokeswoman Carolyn Cichon said. At Minneapolis-based U.S. Bancorp, which owned $6.6 billion of municipal bonds, spokeswoman Jennifer Wendt also declined comment.
Cullen/Frost, which says it’s the only one of the 10 biggest Texas banks to survive the 1980s savings-and-loan crisis, is “extremely comfortable” with the municipal investments, CFO Phillip Green said in a July 1 interview.
$1 Billion in Bonds
The 142-year-old lender, based in San Antonio, bought $1 billion of municipal bonds in the 12 months through February, Green said that month. Most were issued by Texas school districts and insured by the state’s Permanent School Fund guarantee program, he said in last week’s interview.
Municipal debt gained 2 percent in the second quarter underperforming Treasuries by 2.7 percentage points, according to Bank of America Merrill indexes. In 2009, state and local government debt rose 14.5 percent.
U.S. states are likely to face $140 billion in cumulative budget gaps in the coming year, according to the Center on Budget and Policy Priorities. Last year, 187 tax-exempt issuers defaulted on $6.4 billion of securities, the most since 1992, according to data from Distressed Debt Securities in Miami Lakes, Florida.
“It’s a market where it’s clear that the underlying fundamentals are lousy,” said Michael Aronstein, chief investment strategist at Oscar Gruss & Son Inc., a New York- based brokerage. “People can say fundamentals don’t matter but I’ve been doing this for 32 years. They do.”
–With assistance from Dunstan McNichol in Trenton, New Jersey and William Selway in Washington, D.C. Editors: Alec McCabe, David Scheer.
To contact the reporter on this story: Dakin Campbell in San Francisco at dcampbell27@bloomberg.net
To contact the editor responsible for this story: Alec McCabe at amccabe@bloomberg.net.
Don’t throw the keys to the Fed
By Mark T. Williams | July 2, 2009
THE OBAMA administration’s plan to close the existing regulatory gap by using the Federal Reserve Bank as the main systemic-risk regulator is theoretically sound but a bad idea under existing Fed structure.
The Fed employs thousands of examiners stretching from Boston to San Francisco in an attempt to ensure a safe and sound banking system. They are the first line of defense in our banking system, ideally providing a financial firewall against excessive risk taking by physically inspecting banks and ensuring that adequate capital is available to support risk activities. Ratings provide a health scorecard and a comparison with peer institutions.
Although Fed examiners scored major banks such as Citigroup, Bank of America, and Wells Fargo, why didn’t they pick up on the bad banking behavior that President Obama characterized as “wild risk taking’’ on Wall Street? This trend should have been discovered, except that the Fed is adverse to change and its examiners are way behind the regulatory curve.
If the financial market was a gun fight, the Fed would be carrying pea shooters while the Wall Street structured-product gurus would be carrying AK-47s. The sophistication gap facing those charged with measuring and protecting our financial system is staggering.
Meantime, the corporate culture at the Fed has made examiners second-class citizens compared with the more glamorous monetary policy geeks and the economists who roam the marbled hallways. Of the 12 sitting Fed presidents, none came up through the ranks from examiner. Fed examiners continue to have a limited advancement track and salaries at least one-fifth less than those of the people who create the derivatives on Wall Street. How can the Fed attract the best and brightest this way?
The Obama plan would give more responsibility to the Fed at a time when it hasn’t earned it. The recent banking debacle makes clear the Fed has failed to demonstrate that it is capable of taking this added responsibility. Handing the Fed this new duty, given its recent track record, is the equivalent of giving your teenager a new car right after he wrecked the last one. This significant sophistication gap at the Fed, compared with market counterparts it is charged with regulating, is why the Fed didn’t detect the growing risk taking by the major banks. Examiners did not have the adequate training, skills, or tools needed to go head-to-head with the Wall Street rocket scientists.
Why, for example, didn’t the Fed examiners see the growing threat of derivatives? These financial products that got so many banks in trouble were first concocted in the financial laboratories of First Boston and Salomon Brothers back in 1983. The Fed should have had time to amass an understanding of how such derivatives worked, and what kind of financial damage they could cause if used in excess or for the wrong purpose.
But under its current charter, the Fed is not held accountable for a job poorly done. In response to the current banking debacle, there have been no penalties, demotions, firings, or even a public hearing on how and why the Fed dropped the ball. Moreover, when banks do fail (approximately 40 so far this year), it’s the FDIC, not the Fed, that must clean up the mess.
Before the Obama administration expands the Fed’s role and throws it the keys, it is important to fix the varsity-versus-jayvee vulnerability at the Fed. At minimum, this will require that more capital (human and financial) be committed to specialized hiring, training, and increased use of state-of-the-art risk-measurement tools (e.g., computer modeling). The goal is to improve the use of risk-focused exams and to create a skilled examination staff that can detect and halt wild risk taking before the company, market participants, and the economy are harmed.
In addition to the Fed being held more accountable, there must be implementation of performance-based incentives for a job well done. Equally, there needs to be clear consequences to the Fed for poor performance. Only after we plug this regulatory sophistication gap at the Fed can confidence in this agency be restored.
Mark T. Williams, a former Federal Reserve Bank examiner, teaches finance at the Boston University School of Management. 
Penny stocks pillory companies
Question: What could you get with a share of Citigroup Inc. yesterday?
Answer: Change from your dollar. That was true on and off during the day, when shares of the financial giant changed hands for as little as 97 cents before finishing the session at $1.02.
The fact that shares of a company such as Citigroup would trade at penny-stock levels was a shocking development, no matter how much trouble the financial conglomerate faces. But stocks trading below $1 per share, sometimes far below that level, are becoming increasingly common.
The penny-stock ranks are growing as markets continue to take a pounding, sinking more than 4 percent yesterday alone. The Dow Jones industrial average plunged 281.40 to 6,594.44, while the Standard & Poor’s 500 index tumbled 30.32 to 682.55. The S&P benchmark closed at levels unseen since 1996.
US financial shares took a particularly hard fall, but the decline hit all industry sectors and stock markets around the world. Chinese officials dispelled hopes they would add to their stimulus plan, and investors braced for more bad news on US jobs that’s due out today.
Slumping markets have already prompted leading stock exchanges to loosen listing requirements for companies whose shares are under intense pressure. Last month, NYSE Euronext temporarily eased a requirement for companies listed on the New York Stock Exchange to maintain a minimum share price of $1. The Nasdaq Stock Market had already temporarily waived several listing rules, including the $1 per share minimum price requirement.
The danger of delisting is only one headache that develops when a company finds itself in the world of penny stocks. Financing becomes harder to arrange and much more expensive. Stock researchers are less likely to cover shares trading below a dollar, making it less likely investors will remember or remain interested in the business stories of those companies.
Worst of all, a stock that trades for less than $1 looks like a loser. “Once you’re there you’re in a netherworld and you’ve got a death rattle,” says Brian Stack, a portfolio manager at Pioneer Investments in Boston who invests in mid-size stocks.
There are stocks of all sizes in that category. Among companies included in the S&P 500, the ultimate blue-chip stock club, four saw their shares finish below $1 yesterday.
In Massachusetts, 37 of 232 public stocks traded below $1 yesterday. Virtually all of them have been clobbered since the stock market peaked on Oct. 9, 2007. On that sunny day, just five of the same 232 Massachusetts setts stocks were worth less than $1 per share.
Shares of Altus Pharmaceuticals Inc., a Cambridge company working on protein therapeutics, were worth $11.49 each in October 2007. They traded for just 17 cents yesterday. Shares of First Marblehead Corp., the student loan company in Boston, have plunged from $39.09 to 76 cents. Helicos Biosciences Corp., a Cambridge company that makes genetic-analysis equipment, saw its stock tumble from $8.75 to 50 cents. That’s a very long way down.
Stack points out that some small companies with share prices quoted in cents are salvageable businesses victimized by a dearth of stock-trading activity. Anyone who wants to sell shares of a big company like Citigroup can always find a buyer, but an investor unloading the stock of a small business in a bad market may see prices plunge because no one wants to purchase the stock.
The vast majority of Massachusetts companies with stocks under $1 qualify as small. A few names may be familiar, but most are relatively obscure. At those prices, the stocks are probably going to stay under the radar.
Many life-science companies and biotechnology businesses pop up on the local list of shares below a dollar. They usually need multiple rounds of financing to develop products and prefer to go to the stock market for that money. Raising money was their purpose for going public in the first place.
“These biotech companies tend to have a [cash] burn rate,” says Jim Weiss of Weiss Capital Management in Concord. “Until you get a product of some substance approved you have to continually replenish the cash.”
Companies with stocks below $1 are long-shot bets to bounce back, but it does happen sometimes. Shares of Boston’s American Tower Corp. sank to 75 cents in 2002 but climbed back to over $45 last year and closed yesterday at $27.35. Shares of Sonus Networks Inc., a Westford communications company, plunged below 20 cents in 2002 only to recover to more than $8 in 2007. Sonus stock has since slumped back to $1.18.
But most companies with shares below $1 don’t experience any big stock market recovery down the road. Some go out of business, others are acquired at low prices, and others just continue bumping along the bottom of the market.
Shares of Ibis Technology Group Inc., a semiconductor wafer company in Danvers, traded for just a penny each yesterday. But the same shares were worth just 7 cents when the market was riding high in October of 2007.
No matter where a company’s shares start, the penny-stock category is an expensive place that’s hard to escape. More companies are learning that every day.
Steven Syre is a Globe columnist. He can be reached at syre@globe.com.
