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.

Small business loans get big lift

Another sign of a nascent recovery

By Robert Gavin, Globe Staff  |  June 12, 2010

Busy Bee Bakery Melrose - Elin Agustsson held up one of her signature cupcakes in her new Busy Bee Bakery in Melrose. A loan from East Boston Savings Bank helped Agustsson open the bakery. - (John Tlumacki/Globe Staff)

Massachusetts small businesses, seeing prospects improving, are borrowing more money through government loan programs to expand, hire, and start ventures, providing another sign that the state’s economic recovery is gaining traction.

Borrowing through the US Small Business Administration’s primary guaranteed loan program has more than doubled in Massachusetts over the past year, and is on track to match levels not seen since 2005. The loan activity in Massachusetts is also among the most robust in the nation: Only eight other states have had more activity over the past several months, according to the agency.

“SBA activity is a barometer of the economy, and small businesses’ access to capital,’’ said Bob Nelson, director of the agency’s Massachusetts office. “We’re seeing more optimism, more choices for businesses to get capital, and more competitiveness among lenders. There’s certainly a lot more work to be done, but we’re seeing some positives.’’

Credit has been a critical issue for state and national economies, and particularly for small businesses, a major generator of new jobs. In the wake of the financial crisis and deep recession, many banks became reluctant to lend, preferring to hold onto capital they might need to offset bad loans and weather the downturn. Many businesses, in turn, were reluctant to borrow and add debt when the economy was sliding.

“The problem has not been a lack of credit, but a lack of sales and economic activity to support that credit,’’ said Bill Vernon, Massachusetts director of the National Federation of Independent Business, a small business advocacy group. “Now, I think, we’re heading in the right direction. It’s bumpy and inconsistent, but there are more companies doing better than they were a year ago.’’

As the outlook has improved, so has SBA lending. From October through the end of March, the first six months of the federal fiscal year, Massachusetts lenders made 923 SBA loans totaling $142.3 million, compared with 443 loans worth $61.8 million during the same period in fiscal 2009.

SBA loans — commercial loans from banks that are mostly guaranteed by the US government — represent only a small slice of small business lending. In March, Massachusetts banks had more than $9 billion of small business loans on their books, down slightly from nine months earlier, according to the Federal Reserve Bank of Boston. Still, the rebound in SBA lending suggests a change in conditions. As recently as last fall, some Massachusetts businesses were complaining that they couldn’t even get SBA loans through local banks.

In addition to the surge in SBA lending, the number of lenders making such loans has also jumped in recent months, to about 120 from fewer than 90 in the same period last year.

Among the new lenders is East Boston Savings Bank, which has made nearly $2 million in SBA loans since October, according to the agency. One of those loans was for up to $300,000, and went to Elin Agustsson. Two weeks ago, she opened the Busy Bee Bakery near a Melrose commuter rail station, and created 10 new jobs — three full-time and seven part-time. Agustsson, 51, said she had dreamed for years of starting her own bakery, and decided the time was right, despite a still shaky economy.

“Even in a recession, people still need to eat,’’ Agustsson said. “The Obama administration is pushing banks to lend, and banks are looking for people, people they can count on.’’

A number of factors have contributed to East Boston Savings’s move into the small business market, including federal stimulus legislation that increased SBA guarantees to up to 90 percent for most loans, from 75 percent, said Richard Gavegnano, East Boston Savings’s chief executive. Another factor, he said, was the struggle of large national banks hurt in the subprime mortgage meltdown and financial crisis. The bank, with 19 branches in Suffolk County and on the North Shore, has added an executive who focuses specifically on SBA lending.

“With the message clear that government wants to facilitate small business lending, and the megabanks pulling back, we felt there was an opportunity,’’ Gavegnano said. “We want to participate in small business activity, and we’ve ramped up considerably.’’

Small business, which traditionally has been underserved by lenders who preferred to make larger, more profitable loans, is increasingly viewed as a growth market, local bankers said. As a result, the increase in SBA guarantees has provided incentives for some banks to break into small business lending, and for longtime participants in SBA programs to expand their lending.

For example, First Trade Union Bank of Boston, founded by the Massachusetts Carpenters Combined Pension and Annuity Funds, traditionally focused its lending on commercial real estate, bank officials said. It turned toward SBA lending last year as way to further diversify its loan portfolio, bank officials said, and has made more than $6 million in small business loans since October, according to SBA data.

Eastern Bank, the state’s top SBA lender, increased its lending eightfold over the past year, writing more than 170 loans valued at $8.5 million between October and March, according to SBA data. “The fact that we have SBA behind these loans allows us to be more confident and get credit into the hands of small businesses,’’ said Joe Riley, the Boston bank’s executive vice president of retail and business banking.

In many ways, the reliance on the SBA guarantees shows that the economy, credit, and confidence are not back to normal after the historic downturn of the past two years. Still, bankers said, the increased lending demonstrates that conditions are improving. Earlier this week, a Federal Reserve survey found that many New England businesses across several sectors were reporting solid sales and customer demand.

Such companies include Cercone Brown & Co., a Boston public relations and advertising firm. The nine-year-old company, which employs 22, recently received a $250,000 SBA loan through Eastern Bank to help it expand into a new office and nearly double its space. The company has also added two employees and expects to hire more in the coming months.

“When you get more business, you have to move into a bigger office. You need people. You need to invest in new programs,’’ said Len Cercone, a founding partner. “Small businesses are entrepreneurial, and when you add a little capital, you can turn that entrepreneurial spark into a fire.’’

Robert Gavin can be reached at rgavin@globe.com.

Downsizing the big banks: A long-term solution

The hundreds of billions in rescue funds needed to support banks — and the trillions in implicit subsidies — has brought the question of appropriate institutional size to the forefront of regulatory reform. Not surprisingly, FDIC Chairwoman Sheila Bair and Federal Reserve Chairman Ben Bernanke favor measures collectively intended to limit the size of banks in the future, Bloomberg News reports.

Options include raising capital ratios as a bank increases in size, accelerating the increases in fees paid to the FDIC, and lowering the cap on the percentage of nationwide deposits any one bank can take. Overall, the goal is to have “financial disincentives for size and complexity,” according to Bair. Complexity encompasses untraditional banking activities, such as the proprietary trading that drove Goldman Sachs’ (GS) hugely profitable quarter, as well as investing in structured financial products.

There’s no doubt that the majority of large banks took on more risk than they could handle during the last few years. Scale can be helpful in banking, but it can also mean that improper activities are occurring because management’s oversight is less effective. A trillion dollar-plus balance sheet can hide a lot of bad assets and hidden risks. As the too-big-to-fail debate rages on, the real goal is how to avoid a bank that is too-big-to-rescue.

If it seems absurd that the current raft of bailout programs could need to be repeated one day in such a larger size as to be impossible for the U.S. government to finance, consider what’s happening in the financial system now. As certain banks go under (like Washington Mutual) and others are absorbed (like Wachovia) — the result is greater concentration of banking assets under the survivors. I’ve argued elsewhere that this is both a natural and healthy part of market cycles. However, if the government is implicitly supporting existing large banks — keeping them around in the hopes that they can help clean up the mess by taking over other failed institutions — then all bets are off.

The current working plan of regulators and the Treasury Department is to increase concentration in the banking system, but it’s a near-term patch job and the exact opposite of what’s necessary long-term. Promoting stability means promoting an environment where the failure of one does not lead to a potential failure of all, and that’s tough to do when the top handful of financial institutions have huge balance sheets and extensive counterparty entanglements with each other. If that means creating a well-defined line between the dealings of regulated banks and unregulated investment banks or hedge funds, then that discussion should be on the table.

Luckily, America hasn’t yet been confronted with a financial crisis “fix” that exceeds its capacity to borrow. But to ensure that doesn’t happen in the future, institutions need to be appropriately sized so that they aren’t crucial enough to create the hope for financial help when times get tough.

James Cullen edits and writes at CollegeAnalysts.com. He is the vice president of the Boston College Investment Club, which owns shares of GS, but he has no personal position in the stocks mentioned above.