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Statement by
George W. Mitchell
Vice Chairman, Board of Governors of the Federal Reserve System
before the
Committee on Banking, Housing and Urban Affairs
United States Senate

October 18, 1975

I am glad to appear before this Committee today to discuss
the possible implications for the financial system of the New York City
financial crisis.
The threat of a New York City default— and of difficulties
in the tax-exempt market more generally— has caused concern in some
quarters regarding the financial condition of our banking system.
This concern stems from the fact that commercial banks long have been
important investors in State and local government obligations, including
those of New York State and New York City.

I am appending to my

statement a table showing the aggregate involvement of banks in the
tax-exempt market.

As of mid-1975, all commercial banks had total

investments of $102 billion in such obligations, accounting for 47 per
•cent of all outstanding State and local indebtedness.

This was nearly

15 per cent of all the loans and investments of the banking system.
A key consideration leading banks to acquire these large
positions in State and local obligations has been the record of performance
of municipals as a high-quality, low-risk investment.

There are other

reasons banks hold municipals, including their tax-exempt status and
their eligibility as collateral that can be pledged against U.S. and
State and local government deposits.

While such issues do not have the

liquidity and marketability features of U.S. Government issues, the
soundness of such investments has seldom been questioned.

The historical

record for ultimate payment of principal and interest, even among
governmental units that have defaulted on their obligations, has been
remarkably good.




2The record is well documented by the experience of the
depression years of the 1930's, when close to 4800 State and local
units out of more than 150,000 were reported to have defaulted on their
debts, including 48 cities with populations of 25,000 or more.
According to a study published by the Advisory Commission on Inter­
governmental Relations, the indebtedness of the defaulting units at
time of default was $2.7 billion--close to 18 per cent of the total
amount of local debt outstanding.— ' Yet, by 1938, all 48 cities were
^
reported out of default, and by 1945 nearly all units of any significant
size had settled their default problems.

The loss of principal and

interest resulting from recorded defaults during the depression period,
according to a study by the National Bureau of Economic Research, is
estimated to have aggregated only $100 million, or about one-half of
one per cent of the average amount of State and local debt outstanding
in the period.— ^
Experience with municipal debt in the postwar years has
reaffirmed the record for high quality established during the depression.
Although more than 400 State and local default situations had been
reported between 1945 and early 1970, most of these appear to have been
temporary or technical in nature and to have involved quite small
governmental units.

The principal amount of debt reported as in default

1/ City Financial Emergencies: The Intergovernmental Dimension, 1973.
2/ Hempel, George H . , The Postwar Quality of State and Local Debt.
National Bureau of Economic Research, 1971. P. 24. The loss figures do
not include lower interest payments on refunding issues or accrued
interest on unpaid principal or interest.




-3as to principal or interest from 1945 through early 1970 cumulated to
approximately $450 million, or less than one-half of one per cent of
the total municipal debt outstanding in 1970.

And the bulk of this

total— $334 million— was accounted for by revenue bonds on three major
projects— the West Virginia Turnpike,
Chesapeake Bay Bridge and Tunnel.

Calumet Skyway Toll Bridge, and

An additional $72 million was accounted

for by 21 other default situations involving amounts of $1 million or
more, of which only two were general obligation bonds.
This experience leads me to believe that the chances of
ultimate significant loss, especially by investors in general obligation
bonds, are relatively small.

Even if New York City should default for

a time on its obligations, the economic tax base will remain and the
City will have to cure the default in one way or another before it
can reenter the credit market.

In view of the high probability of

ultimate final repayment— which means that the securities will continue
to have market value— the Federal bank supervisory agencies have agreed
that a reasonable length of time will be permitted, if there is a
default, before banks would be required to write down the book value
of their holdings to market value.

During this interim period of up to

six months, the default might well be cured and markets return to
normal.

But even if this does not happen, it is important to recognize

that the amount charged off against a bank's capital account would
undoubtedly be far less than the book value of the security holdings
involved.




-4 We nevertheless have reviewed our most recent examination
reports— some of which may date back for a year or so— 'to determine the
extent to which concentrations of holdings of New York City or State
securities may exist among our State member banks.

1 am submitting a

staff report summarizing this study for the information of the Committee.
It shows that only 6 of our roughly 1,100 State member banks held
New York City securities amounting to more than 50 per cent of the
bank'8 capital as of the last examination; in some cases, these positions
may well have been reduced or eliminated since that time.

If holdings

of New York State and State agency issues are included as well, the
number of banks with such investments aggregating more than 50 per cent
of their capital is raised to only 17; most of these are quite small
institutions.
It does not appear, therefore, that there is a significant
threat of capital impairment, at least among the State member banks.
The studies conducted by the Comptroller of the Currency and the Federal
Deposit Insurance Corporation, I believe, reach more or less similar
conclusions.

A more likely possibility is that, in the event of default

by the City, some banks will experience a temporary liquidity squeezearising, for example, from sudden shifts of deposits from one bank to
another, or because banks are faced with unexpected requests for
credit accommodation by their municipalities, or by holders of the
defaulted bonds, or by dealers in the municipal securities market who
for a time may be unable to liquidate their inventories of bonds.




5
In the event that such a temporary liquidity squeeze should
develop, the Federal Reserve has ample power to provide additional funds
to its member banks— and to nonmember institutions when other sources
of funds are not available— through loans at the Federal Reserve Bank
discount windows.

The Board has adapted its contingency plans to deal

with such an emergency, and I want to assure you, as Chairman Burns has
done before other Committees, that we are prepared to act promptly
and in whatever scale is deemed necessary to assure an orderly financial
environment.

We recognize that such special extensions of central bank

credit might have to be sizable and could risk a substantially larger
expansion in money and credit than is desirable over the longer run,
Such credit accommodations would therefore have to be of a temporary
character, and would need to be reversed later on, but they nevertheless
would be made readily available in an emergency situation.
I do not want to suggest that a default by New York City would
not be a very serious matter for financial markets as well as for the
City.

But I do believe that the public need not fear for the stability

of our banking system if a default does in fact take place.

We have

ample capability to provide the liquidity that the financial system may
need in such a time of crisis— liquidity which, when supplied in timely
fashion and adequate amounts, should help confine the damage in the
municipal securities markets to only those who are most directly
involved.




-0 0O

ATTACHMENT I

COMMERCIAL BANK HOLDINGS OF STATE AND LOCAL GOVERNMENT DEBT
(End o f y e a r t o t a ls except where in d ic a te d )
S ta te and Local
Government Debt Outstanding
Bank Share
(P e r Cent)

Commercial Bank C r e d it
H oldings o f S ta te &
S ta te & Lo cal
Lo cal Government Debt
Debt Share
($ b i l l i o n s )
(P e r Cent

Year

Amount
($ b i l l i o n s )

1960

7 0 .8

2 5 .0

203.7

17.7

8 .7

1965

100 .3

3 8 .8

310.4

3 8 .9

1 2 .5

1970

144.4

4 8 .6

459 .2

7 0 .2

1 5 .3

1975

216 .2

4 7 .3

708.9

1 02 .3

1 4 .4

In c re a se from
12/60 to
6/30/75

T o ta l

Amount
($ b i l l i o n s )

t>er ce n t
In c re a se

S ta te & Local G ovt.
Debt Outstanding

145.4

205 .4

Commercial Bank
Holdings o f S ta te &
Local Govt. Debt

8 4 .6

478.0

Bank sh are o f
In c re a se in S ta te &
Local Debt O utstanding

S o urce:

Fed eral R eserve Flow -of-Funds A cco unts.




5 8 .2

ATTACHMENT II
REPORT OF A SURVEY OF SIGNIFICANT STATE
MEMBER BANK HOLDINGS OF THE OBLIGATIONS
OF NEW YORK CITY, NEW YORK STATE, AND
NEW YORK STATE AGENCIES
September, 1975
In order to determine the potential exposure among State
member banks to adverse developments in the market for municipal and
State obligations of New York, each Federal Reserve Bank in August
of this year was requested to provide information about State member
banks which held concentrations of New York City, New York State,
or New York State Agency securities as of the last examination
report.

For this purpose,

a concentration was defined as holdings

amounting to more than 10 per cent of a bank's capital for any of
the three groups, or to more than 20 per cent of capital for the
three groups combined.

Principal New York State agencies included the

Housing Finance Agency, the College Dormitory Authority, and the
Urban Development Corporation.
The selection of the 10 per cent lower cutoff of holdings
of a single group of securities relative to capital was made in view
of the fact that loans to a single borrower are normally limited to
10 per cent of capital.

While the limitation does not specifically

apply to a bank's holdings of municipal securities, it was deemed
appropriate for the purpose of assessing any possible points of
potential bank exposure.
It should be noted that the data on securities were reported
at par value, and were taken from examination worksheets on hand at the
Reserve Banks that were not necessarily current but may date from as




-2long as a year ago.

Over the intervening period, it seems probable

that institutional holders had lightened their investments in New York
obligations, on balance, especially since the Urban Development
Corporation default on February 25, 1975.

Moreover, the data on

securities holdings were not broken down by maturities.

Many holdings

could have been short-term debt and by now have been liquidated.
Of the 1,064 State member banks, 130 or about 12 per cent
of the total fell within the survey guidelines.

Fifty-one of the

banks reported are located in the State of New York.

The remaining

banks are scattered throughout the country.
Table I reflects data for 112 of the survey banks which
held New York City obligations.

Seventy-seven of these banks held

debt of the City amounting to only 10 to 20 per cent of capital.

Of

the remaining 35 banks, six banks held New York City debt amounting
to over 50 per cent of capital; but five of the six were smaller banks—
with less than 10 million in total capital.
When holdings of New York State and New York State Agency
obligations are added to the analysis, the majority of banks fell
into the 20 to 50 per cent of capital category as shown in Table II.
This shift is primarily due to significant holdings of New York State
debt.

Seventeen banks were reported with total New York City, New

York State, and New York Agency obligations greater than 50 per cent
of capital.

However, 15 of these banks, again, were smaller banks—

with less than 10 million in total capital .




On the whole, the State member banks with holdings of New
York obligations reported in the survey were rather small in size.
Moreover, the percentages of capital reported do not represent cause
for alarm and, as previously indicated, the incidence of potential
exposure has probably decreased since the last examination.

In the

view of the Division of Bank Supervision and Regulation, though there
were a few State member banks with holdings of New York obligations
representing relatively high percentages of capital, the situation
on the whole appears to be quite manageable.




TABLE I. DISTRIBUTION OF STATE MEMBER BANKS
BY CAPITAL ACCOUNT AND BY HOLDINGS OF NEW
YORK CITY OBLIGATIONS AS A PER CENT OF CAPITAL
Capital Account
(In millions of dollars)

New York City Obligations as
______ Per Cent of Capital_____
10-20%
20-50%
Over 50%
(Number of banks)

Less than one

12

2

46

1 to 10

9

12

3

—

—

10 to 25

8

Over 25

14

5

1

77

29

6

Totals

TABLE II. DISTRIBUTION OF STATE MEMBER BANKS
BY CAPITAL ACCOUNT AND BY HOLDINGS OF TOTAL
NEW YORK CITY, NEW YORK STATE, AND NEW YORK
STATE AGENCY OBLIGATIONS AS A PER CENT OF
CAPITAL

Capital Account
(In millions of dollars)

Total New York City, New York
State, and New York State
Agency Obligations as Per
Cent of Capital
Over 50%
10-20%
20-50%
(Number of banks)

Less than one

5

14

5

1-10

31

37

10

10-25

2

6

—

Over 25

3

15

2

41

72

17

Totals