Municipal Bonds and Commercialbanks

Municipal Bonds and CommercialBanks

James M. Hushagen

Eisenhower Carlson PLLC

February 5, 2013

1.INTRODUCTION

1.1Brief overview of municipal bonds and how commercial banks can get involved in them.

1.2No discussion of:

1.2.1Corporate bonds or of municipal bonds in which commercial banks are generally not involved

1.2.2Complex calculation of the yield on municipal bonds or the pricing/setting of the interest rate

1.2.3Bank trust department involvement as trustee or payment agent or

1.2.4Investment bank involvement as underwriter, etc.

2.WHAT IS A MUNICIPAL BOND?

2.1A debt obligation issued by states or their political subdivisions; e.g.local governments, or quasi-governmental agencies authorized to issue such debt obligations

2.1.1Local governments include counties, cities, ports, school districts, etc.

2.1.2Quasi-governmental agencies include housing authorities, economic development authorities, housing finance commissions, higher education finance commissions, etc.

2.2A debt obligation upon which the interest paid to the holder thereof is exempt from federal income tax.

3.HOW ARE COMMERCIAL BANKS INVOLVED IN MUNICIPAL BONDS?

3.1Purchase of bank-qualified bonds

3.2Credit enhancement of non-bank qualified bonds

4.PURCHASE OF BANK-QUALIFIED BONDS

4.1General rule: Commercial bank may not deduct the “carrying cost” (expense incurred to purchase or carry an inventory of securities) of most municipal bonds

4.1.1Largely eliminates tax-exempt benefit of municipal bonds

4.1.2But, carrying cost limitation does not apply to bank-qualified bonds, making them more attractive to commercial banks

4.2Commercial banks are allowed to deduct 80% of the “carrying cost” of bank-qualified bonds

4.3Bank-qualified bonds are

4.3.1Issued by a “qualified small issuer;” e.g. issues less than $10 million in tax-exempt bonds during any calendar year[1]

4.3.2Issued for a public purpose, and

4.3.3Designated as tax-exempt obligations

4.4Purchase is relatively simple transaction

4.4.1Two-party transaction

(a) Issuer/borrower issues bond

(b) Commercial bank purchases bond from issuer

4.4.2Occasionally three-party transaction

(a) Financing agency/issuer (WSHFC) issues bond for benefit of borrower

(b) Commercial bank makes loan to borrower

(c) Issuer sells bond to commercial bank in exchange for the loan

4.4.3Documented similarly to any commercial loan (real and personal property collateral, resolutions, environmental indemnity, etc.) sometimes with bond, rather than promissory note, as the debt instrument

5.CREDIT ENHANCEMENT OF NON-BANK QUALIFIED BONDS

5.1Not based on any tax benefit to commercial bank; rather, as accommodation to good customer who wants low interest long-term tax-exempt financing

5.2Fairly complex process

5.2.1Issuer (usually state or local public finance agency) issues industrial revenue bonds to lend proceeds to small business (bank customer) at low interest rate and long term for business expansion purposes

5.2.2Source of repayment of bond is small business/bank customer, not bond issuer or government

5.2.3Underwriter (usually investment bank) sells bonds on the open market to investors (not generally commercial banks) that can take full advantage of tax-exempt interest

5.2.4Since small business is source of repayment, bid interest rate on bond is generally high due to lower creditworthiness because of higher likelihood of nonpayment

5.2.5To enhance the credit rating of the bond issue, local commercial bank issues direct pay letter of credit for benefit of bank customer, promising to make all bond payments.

5.2.6If local commercial bank is not sufficiently creditworthy to enhance credit of bond issue, larger bank issues back-up letter of credit with local commercial bank issuing maintaining primary letter of credit.

5.2.6Bank customer promises to reimburse local commercial bank for all bond payments made through draws on the direct pay letter of credit and secures promise with real and personal property collateral and guaranties from principals of business.

5.2.7Bank customer/borrower pays letter of credit fee to one or both commercial banks issuing letter(s) of credit.

5.3Reasons for local commercial bank to do credit enhancement bond transaction

5.3.1Remain primary bank for good customer

5.3.2Fund commercial loan with letter of credit

5.4Reasons not to do credit enhancement bond transaction

5.4.1Letter of credit fee does not generate much revenue, especially if split with larger bank.

5.4.2Significant upfront costs for borrower, including bond counsel, underwriter, underwriter’s counsel, trustee, trustee’s counsel and local commercial bank counsel.

6.CONCLUSION

6.1Bonds represent good opportunity for local commercial bank to provide attractive financing solutions for good public sector customers

6.2Purchase of bank-qualified bonds issued by current public sector customers seems more attractive than credit enhancement because cost to customer of purchase is lower than credit enhancement because of (a) no underwriter or underwriter’s counsel and, usually, (b) no trustee/payment agent

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[1] The American Recovery and Reinvestment Act of 2009 (“ARRA”) increased the $10 million limit to $30 million for bonds issued in 2009 and 2010. These provisions expired by their terms in 2011 and Congress has not yet renewed them.