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MUNICIPAL SECURITY ANALYSIS AND BANK INVESTMENT PROBLEMS




MUNICIPAL SECURITY ANALYSIS AND BANK INVESTMENT PROBLEMS

By
Raymond E. Hengren
Deputy Chief
Division of Research and Statistics
Federal Deposit Insurance Corporation

l+7th Annual International Conference on Municipal Finance
Municipal Finance Officers Association
of the United States and Canada
Miami, Florida
May 31-June *4-, 1953

Municipal Security Analysis and Bank Investment Problems

Directly or indirectly, a very substantial portion of the efforts
of a municipal finance officer is devoted to problems touching upon the
credit standing of his governmental unit.

Financial management and the

reflection of it in reports are the more conspicuous aspects of this work.
But the finance officer in concentrating attention on management and
reports is concerned only with one side of the coin; the reverse side of
this same coin shows the investment problem and the analysis of securities.
The background for this discussion of the bank investment problem
and the related analytical techniques for judging municipal credit will be
sketched by focusing attention on two questions:
(a) To what extent do State and local governments rely on
commercial banks for long-term credit requirements, and
(b) How important are the obligations of these governmental
units in the asset structure of the commercial banks?
The answer to the first question will suggest the extent to which it is
necessary to take banks into account.

Some insight as to the nature of the

banks’ investment requirements will be developed from the answer to the
second question.

To be sure, a finance officer cannot shape his entire

credit requirements to fit the specific investment needs of any one
supplier of funds, but it would be foolhardy to ignore the place occupied
by banks in the investment market.
How the technique of security analysis is used in judging credit
quality for the purpose of selecting investments will also receive a good
share of our attention.




The financial report covering the operations of a

-

2

-

municipality is of crucial importance in this analytical process.

An

understanding of security analysis will enable the finance officer to
develop his report so that it may be used effectively in solving investment
problems.

Most important of all, however, it is hoped that a discussion

of analysis will encourage continued improvement in the quality of
reporting.

Commercial Banks as Suppliers of Credit to Municipal Governments
Some graphic material has been prepared to illustrate the
answer to the first question:

To what extent do States and other

governmental units rely on commercial banks for long-term credit?
Information regarding the ownership of securities issued by State and local
governments is presented in the accompanying chart.

The data covering the

period 1937-1952 were obtained from the 1952 report of the United States
Secretary of the Treasury.

Columns in one of the chart panels depict the

dollar amount of securities outstanding.

Each of the columns is broken

into segments indicating the major classes of investors.

The relative

amount of securities held by each ownership segment is presented in the
adjacent chart panel.




¥
BILLIONS OF DOLLARS

3 0 ------------------------------------------------------------------------------------------------------- —

--------------------------------------------------------¥

--------------------------------------------------------

OWNERSHIP OF SECURITIES ISSUED BY STATE
AND LOCAL GOVERNMENTS

----------------------------------------------------------------------------------------------------------*--------------------------

30

PERCENTAGE OF TOTAL OUTSTANDING
20 —
10

0

1937 1938 1939 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952



>

\ INSURANCE COMPANIES
> AND MUTUAL SAVINGS BANKS

— 20

From these data you will note that the volume of outstanding
municipal securities has now increased by nearly $10 billion above the
pre-war level of approximately $20 billion.

Moreover, the commercial banks

have grown in stature as holders of these securities over the years.

The

increase in the dollar volume of their holdings is quite impressive.

At

the present time the banks have in their investment accounts more than
one-third of all outstanding municipal securities.

This position has been

attained through a period of steady progress from the pre-war level of
about 15% of the total.

Furthermore, the trend continues to point sharply

upward.
As one point of reference it is interesting to observe that
during World War II the commercial banks never held as much as one-third of
the outstanding Federal obligations.

To be sure, this involved a much

larger amount than is comprised by the fraction of municipal securities
currently held by the banks.

Nevertheless, States and other subdivisions

of government today are leaning very heavily on the commercial banks for
credit.
Changes in the relative importance of the different classes of
investors supplying municipal credit are worthy of careful study by the
finance officer.

Here attention has been concentrated on the role of the

commercial banks, but the shrinkage in the importance of other investor
groups should not be ignored.

The long-run significance of these trends,

however, is an intricate subject which may have an important bearing on the
entire economy.




• 2^ •

Reliance by States and other subdivisions of government upon the
commercial banks for credit makes it important that finance officers
understand their investment requirements and limitations.
may well be described as a unique class of investors.

Commercial banks

Qualitywise and in

other respects, the commercial banks have rigid investment requirements.
Specifically, their need for readily available credit information is more
exacting than others who invest in municipal securities.

Municipal Securities in Commercial Bank Portfolios
Now let us look at our second question:

How important are

municipal securities in the asset structure of the commercial banks?
accompanying chart presents data for the period

The

1937-1952 regarding the

securities of State and local governments held by commercial banks.

This

information was compiled by the Federal Deposit Insurance Corporation.
Both the dollar amount of the holdings and the percentage of total
resources committed to these securities have been pictured.




BILLIONS OF DOLLARS
10----------------




SECURITIES OF STATE AND LOCAL GOVERNMENTS
HELD BY COMMERCIAL BANKS

PERCENT

— 6

1937 1938 1939 1940 1941 1941 1943 1944 1945 1946 1947 1948 1949 1950 1952 1952

-5With holdings which now aggregate almost $10 billion, commercial
banks have increased their investments in the obligations of States and
local governments by almost $7 billion over the level in the years before
World War II.

You will recall from the preceding chart that the volume of

outstanding municipal securities exceeds the pre-war level by about
$10 billion.

Thus It appears that an amount equal to about $7 billion of

the $10 billion increase in outstanding debt volume has found lodgment in
the commercial banks.

This is a development which certainly is worthy of

sober thought.
The rapid post-war growth in commercial bank holdings of municipal
securities has given rise to much comment in the financial press.

From the

chart, however, you can see that in relative terms the size of the
portfolio is not without precedent.

Prior to World War II banks committed

about 5$ of their total resources to municipal securities.
years, the commitment declined to a low of about

In the war

of total resources.

Since then, however, the recovery has been rapid and now the percentage has
returned to the pre-war level.

However, commercial banking resources have

grown to about $185 billion, and 5$ of the total comprises a municipal
portfolio approximating $10 billion.
There is no reason to believe that 5# is a standard for the
amount of commercial bank resources to be invested in municipal securities.
As a matter of fact, the proportion may very well climb higher, just as in
recent years it has declined to a much lower figure.

This ratio depends

really on banking considerations and not upon historical precedent— in part
upon the availability of funds in the commercial banks which may be




- 6 committed to investment securities, and in part upon the extent to which
this class of obligations measures up to the investment requirements.

Bank Portfolio Management
A look at our subject from the viewpoint of those charged with
responsibility for the management of bank investments will be the next step
in this discussion.

The quality of municipal securities deemed to be

suitable for bank investment purposes will be considered first.

This will

be followed by a few remarks on bank requirements for a schedule of
maturities in the investment portfolio and for the marketability of the
securities.

Finally, some consideration will be given to diversification

of items in the portfolio.
The qualitative standards for investment securities held by the
commercial banks are very high.
the nature of commercial banking.

These high qualitative standards stem from
Banks hold the liquid resources of the

communities they serve in the form of deposits credited to their customers.
As a practical matter, most of the deposits are payable upon demand,
although some are subject to time restrictions on withdrawals.

If economic

tragedy is to be averted, the affairs of commercial banks must be so
managed that depositors can be paid when they request their deposits.
In managing the resources of a bank, experience has demonstrated
that part of the assets may properly be invested in securities.

These

investments, however, are viewed as a ready source of cash should the need
arise.

As a consequence, they cannot be subject to value deterioration.

While high investment quality by itself may not be sufficient to prevent




- 7 the erosion of asset values* it is one of the ingredients which together
with other elements will preserve values*
Other classes of investors are not subject to the same pressures
as those which impinge on banks to find securities of top quality.
Obligations of ordinary, or for that matter, even marginal quality
frequently offer attractions to non-bank investors, such as private
individuals• Elements of uncertainty which may not have been properly
discounted in market prices often furnish private investors an opportunity
for profit.

But the risks inherent in these situations are such that the

opportunities can never be attractive to the commercial banks.
At times municipal finance officers may feel that commercial
banks are unduly apprehensive about the quality of securities in the
municipal portfolio.

Bank investment managers, like municipal officials,

are obliged to maintain a public viewpoint.

To them, the bank investment

situation cannot be viewed as a private affair.

The interest of the public

generally is at stake and there is no alternative but to commit bank funds
to securities which measure up to the high qualitative standards which will
avoid misfortune for the community as well as the individual bank.
matter of quality there is no room for compromise.

In the

To do so is a certain

step in the direction of misfortune.
Next, let us turn to a consideration of maturity schedules and
marketability for the items in the municipal portfolio of a bank.

In each

individual commercial bank there is a characteristic ebb and flow of funds.
At times funds tend to accumulate.




Then, in other periods, they shrink.

-

8

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This fluctuation in the amount of bank funds is reflected chiefly by
changes in the deposits, loans, and in reserves*
Because the managers of bank investment portfolios are especially
conscious of the ebb and flow in deposits and requests for loans, they
endeavor quite systematically to build into their investment programs
certain features which will make cash available to them at the proper time.
This is accomplished by selecting bonds whose maturities are expected to
coincide with the time when an outflow of funds is antic ipated.

Each bank

has its own rate of turn-over in deposit accounts as well as a pattern of
activity in the demand for loans.

Accordingly, the schedule of maturities

is adjusted in conformity with these anticipations.
The fact that deposits in a commercial bank ordinarily do not
remain undisturbed for a long period of time is one of the important
reasons why managers of bank investment portfolios do not look with favor
upon securities which mature in the distant future.

A rapid turn-over of

investment funds through the maturity schedule provides the commercial bank
with a steady in-flow of cash.
of deposits, they are available.

If the funds are needed to meet withdrawal
Should they not be needed for this

purpose, the portfolio manager may, of course, reinvest them*
High quality investments in a bank portfolio are not a substitute
for appropriate maturity dates.

Irrespective of quality, it is a

mathematical fact that changes in the prevailing rate of return on any
class of investments cause proportionately greater fluctuations in the
capital value of long-term than short-term issues.

To avoid the risk of

loss in capital values, therefore, it is a well-recognised tenet of bank




investment policy that holdings should be confined to securities which will
mature within the next few years*

A bank portfolio of short-term

obligations, for example, maturing within a period of five years, has an
inherent value-sustaining element that is absent in long-term issues*
While it is possible to convert a portfolio of municipal
securities into cash through sales in the market that, as a general rule,
is not practical.

For the most part, transactions in municipal securities

involve more or less extensive negotiations between buyers and sellers*
To be sure, the market for many of these obligations is broad and active.
But there is a vast number of issues and formal or organized exchanges have
not developed for trading municipals.
There are certain classes of investors other than banks, namely,
private individuals or pension funds, who need not be concerned with
maturity schedules.
periods of time.
undisturbed.

They can anticipate their requirements over long

Very frequently, they need investments which will remain

But commercial banks have an entirely different problem.

They need short maturities, not long ones.
A few other basic considerations in the management of a bank
investment portfolio are deserving of consideration.

The principle of risk

diversification is one that frequently receives considerable attention.

It

is certainly desirable to build up a portfolio from items which represent
as broad a credit base as possible.

Diversification, however, does not

mean that a bank portfolio will include a scattering of commitments over a
large geographical area.




It entails a far more sophisticated approach in

- 10 -

the selection of securities*

As a matter of fact* diversification

frequently is achieved by confining investments chiefly to the obligations
of municipalities with a strong and well-diversified economic background.
Income from municipal securities is not subject to Federal income
taxes*

This tax exempt feature is especially attractive to banks because

they derive earnings chiefly from interest on loans and investments*
However, it is not consistent with sound practices for a bank to maximize
its tax-free income by concentrating investments in municipals affording
the highest yield*

When bonds are selected for inclusion in a portfolio,

yield is one of several important considerations*

Other factors, such as

quality and maturity, also are important.

Municipal Security Analysis
Knowledge of municipal security analysis techniques, and of the
part analysis plays in the investment process may be useful to the municipal
finance officer*

Viewed narrowly, his activities in this area are limited

to the preparation of reports.

Good financial reporting, however, links

security analysis and bank investment in municipals.

Analysis furnishes a

rational basis for guiding decision when it is necessary to select
investments among the many alternatives available in the market.
To cover the subject of municipal analysis systematically and in
detail is far too ambitious a task for this occasion.
to sketch the broad outlines.

But it is practical

You fill find exhaustive treatments of the

subject in the standard textbooks covering the field of investments.
Municipal security analysis is not a cut-and-dried procedure and
there are no pat answers to the basic questions.




It is an empirical and

11

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practical technique designed to help determine the suitability of a
security for investment.

Security analysis is scientific in the sense that

it is based on observation and orderliness of study.

Ultimately, however,

analysis is an art because it involves a chain of decisions each of which
rests upon qualitative judgments.

Although it is necessary to review the

basic information in any case systematically, there is no established
formula to be followed in analysis.

The final answer is a composite

judgment supported by many intermediate determinations.
these determinations frequently are inconclusive.

Pacts to support

Far too often they are

impossible to obtain.
Later on, some reference will be made to the application of
recognized investment standards in the process of municipal security
analysis.
data.

These standards are useful for measuring the significance of

They have grown out of experience.

Nevertheless, they should not be

thought of as immutable yardsticks.
Appreciation of municipal security analysis techniques will
increase the effectiveness of a finance officer in managing a debt.

If he

knows something about analysis, it will be much easier for him to assemble
and make available to the public generally the kind of information required
by managers of investment portfolios.

Moreover, the finance officer will

be able to anticipate the extent to which the obligations of his
governmental unit will be appropriate for bank investment purposes.

The

fact that some municipal issues cannot be expected to attract bank funds
will not come as a surprise to him because he will understand the reasons.
Undoubtedly there have been times when a municipal finance officer’s lack




-

12

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of knowledge regarding the technique of security analysis has reacted
adversely for the credit standing of his municipality.
The purpose of municipal security analysis is to answer one
simple question:

Will the municipality pay its obligations in accordance

with the terms of each individual bond issue?

There is no attempt to

appraise the goodness of credit in any absolute sense.

Sufficient for the

purposes of the portfolio manager is an informed opinion on the prospects
for investment performance.
The reason for narrowing the question to the outlook for a given
bond is not hard to see.

Nor is it enough that in the long run the credit

of a governmental unit will be satisfactory.

Delays in payment of interest

or principal on a specific issue, even for a short time, will make the
obligation unsuitable to certain investment programs.

This is especially

true for banks.
Municipal security analysis involves the sifting and appraising
of economic and financial information.

It tries to identify the controlling

factors with respect to a particular security.
the obligation is assumed to be valid.

In the process of analysis

Determination of legality has

developed into a highly specialized branch of the law.

As a practical

matter, investment analysts are obliged to rely upon the experts in
determining the legal characteristics of each bond.

After the analyst has

satisfied himself that the obligation under consideration is valid, he then
sets about to isolate the crucial elements bearing upon investment standing.
A review of the economic background of the governmental unit
issuing bonds is basic in the analysis of municipal securities.




Of

- 13 necessity the scope of this review is quite broad.

It encompasses such

topics as the natural resources of the area, population change and
industrial development.

To be of maximum usefulness it is necessary to

cover the past record of development as well as the future prospects.
Sometimes it is easy to trace the essential features of the economic
background in analyzing municipal credit#

More frequently, however, the

analyst is confounded by the mass and complexity of details.

Up to now,

most reviews have tended to be historical and subjective in character.
Some excellent economic studies of areas have been prepared by
research workers in universities.

In these studies the data have been

selected with discrimination and the results have been organized and
expressed clearly in well-written reports.

A municipal finance officer may

obtain guidance from these studies in analyzing the economic background of
his area.

Moreover, he has an intimate knowledge of his own community, and

with a little guidance he can open up a storehouse of economic information
for use in analytical work.
Facts regarding the debt structure of an issuer play an important
part in answering the central question in municipal security analysis.
Both the size and composition of the debt are significant.

Of importance

likewise is the trend in the amount of debt and the prospects for future
change.

By itself, fluctuation in the amount of debt is a neutral fact*

But it may become significant when joined with others in the analytical
process.

During years of expansion, a growing debt may be bearable.

On

the other hand, in a period of disintegration, trouble will arise if the
shrinkage of debt is not commensurate with the decline in economic strength.




-

Ik

-

The municipal finance officer can help the analyst by assembling the data
on debt structure and presenting this information in its proper frame of
reference.
The report on the current financial operations of an issuer is a
primary source of information for municipal security analysis.
report is of major concern to the municipal finance officer.

Also, this
Information

on the amount and composition of income and the principal items of
expenditure is furnished by this report.

Its usefulness in answering the

central question in security analysis depends upon the quality of the
accounting which supports it and consistency in the manner of its
preparation over a period of years.

When the reports reflect good

accounting practices, an analyst has a basis for confidence in his judgment.
On the other hand, shaky accounting or carelessness in reporting tends to
weaken confidence even in situations which otherwise may be satisfactory.
In studying the margin for financial protection of debt service,
the crucial question in security analysis is brought to sharp focus.
Rephrased, the question is this:

Has the obligor covered the expenses of

operation by a margin adequate to maintain debt service even in periods of
adversity?
The work of an analyst is greatly simplified when the financial
reports are designed to show in clear-cut fashion the principal elements to
be considered in judging the margin of debt service protection.

In

preparing these reports, there is no formula of universal applicability.
Form depends on the individual circumstances in each case.
In municipal security analysis it is essential both to earmark
the important facts and to measure their significance in terms of recognized



- 15 investment standards.

For example, the general property tax has long been

relied upon as the principal source of income for municipalities.

Moreover,

the ratio of debt to assessed value is generally accepted as an indicator
of debt burden for obligations supported by the general taxing power of the
issuer— the so-called full faith and credit securities*

The rationale of

this debt ratio measure has been well-established in the financial literature.
Comparison of the ratio in a given case with standard debt ratios for the
area helps to guide judgment as to the investment quality of the obligation.
As illustrative of the complications in municipal security
analysis, however, it should be noted that sometimes the ratio of debt to
assessed value is an unsatisfactory measure for judging the quality of a
general obligation.

When the obligor relies only to a very limited extent

upon the general property tax as a source of income, the debt ratio
measures nothing that is important.

Also, there are instances of assessed

values which have become so thoroughly distorted that any computation based
upon them can only be misleading.
To demonstrate the quality of an obligation supported by the
general credit of the issuer, there is need for evidence that the local
government has a margin of unused taxing power supported by adequate
economic resources.

When analysis indicates that the debt burden measure

is not appropriate in a given situation, then it is necessary to adopt the
broader approach in order to appraise credit quality.

For municipal

finance officers, considerations such as these emphasize the versatility of
the analytical process.
Turning now from the analysis of general obligations to another
category of bonds, namely, the ones issued to finance activities of a



- l6 business type, such as electric utilities— for these issues it is easy to
find well-recognized investment standards for fudging credits in the field
of corporate security analysis.

To be sure, the unit of government

conducting business activities may enjoy certain tax advantages.

But these

features are taken into account in the process of analysis and the results
are tested by the established rules for judging efficient operations and
debt service coverage.
By contrast, when municipal security analysis is applied to
obligations whose credit rests on the pledge of income from a specific tax,
the problem of judging quality is likely to be quite stubborn.

Occasionally

these cases are further complicated by a general pledge of credit that is
difficult to evaluate.

In some instances it seems virtually impossible to

appraise the margin of protection for the bondholders.
In this brief sketch of municipal security analysis, the process
of sifting pertinent facts has been outlined and some stress has been
placed upon the selection of appropriate investment standards for
appraising the data.

Broad experience in the field of analysis furnishes

the only basis for classifying obligations into homogeneous groups for
which standards may be developed.

Before a standard is applied in a given

situation, it is necessary to arrive at a judgment as to its
appropriateness.

This judgment rests almost solely upon experience.

Many short cuts have been suggested from time to time in order to
simplify municipal security analysis.

Occasionally these short cuts have

served the purpose very well although that can be demonstrated only by the




- 17 conventional procedure for analysis.

Nevertheless* there have been times

when the answers produced by the short cuts were exceedingly misleading.
As a matter of fact* easy and quick answers in security analysis are not
likely to be good ones even though they would be very desirable.
This concludes a very brief review of municipal security analysis
which was designed merely to highlight the major points in the process.
The review has served its purposes if it reminds the finance officer that
the analytical work rests upon his reports.

Good security analysis

requires his wholehearted cooperation as an essential prerequisite.

Summary and Conclusion
To sum up then* the chief purpose of this discussion has been to
explain why municipal finance officers should concern themselves about bank
investment problems and analytical techniques for determining the
investment qualities of municipal, securities.

There may be a tendency to

overlook the importance of these considerations.
Facts were presented to show the role of banks as suppliers of
credit to States and other units of government and the place occupied by
their obligations in the asset structure of the commercial banks.

These

banks now furnish about one-third of the credit extended to municipalities
through ownership of securities* whereas in
little more than 15$.

1937 this proportion was only a

The amount of municipal obligations in bank

portfolios has increased from a level of about $3 billion at the end of
World War II to approximately $10 billion.

However* the proportion of bank

assets invested in municipals now has returned to the 5$ level which
prevailed over the pre-war years.



- 18 Following the development of this factual background, your
attention was centered briefly on a few of the basic principles in managing
a bank investment portfolio.
requisite for bank assets.

Stress was placed upon high quality as a
In addition, there was a brief comment

regarding the maturity schedule for bank investments as an element in
managing funds.

Also, some consideration was given to other factors such

as the distribution of risks.
So that you would have a better understanding of the purposes
served by your financial reports in the bank investment process, municipal
security analysis techniques were reviewed briefly.

This review was

developed around the basic question which analysis seeks to answer, namely:
Will the obligation under study be paid according to its terms?
The municipal finance officer is in a strategic position to
facilitate the investment process.

With properly designed reports, he can

convey a feeling of confidence in the judgment which investment analysts
reach in the course of their work.

This is only one of the many facets of

financial management, but it is vital nonetheless.