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ConforoncG of Supervising Examiners

April k , 5, and. 6, 19^9

Trends in Bank Holdings of Municipals
By Raymond E. Hongren
Division of Research and Statistics

Recent developments with respect to the obligations of States
and minor political subdivisions and their financial affairs have di­
rected the attention of the banking supervisory authorities towards the
portfolios of municipal securities.

Among these probably the most

dramatic was the sharp reversal in the long term trend of municipal
bond yields which occurred in 19^6.

Market conditions at that timo _

enabled municipalities to float securities with coupons as low as 1$
and maturing in the next generation at prices near par.
ation has changed.

Now this situ­

A reversal in yields has forced prices on the out­

standing long term, lew coupon securities to discounts of as much as
20$ or 30$.

Questions about the municipal portfolio should not be

too surprising in these circumstances.
The financial problems confronting the issuers of municipal
securities at the present time have been the subject of widespread dis­
cussion in the financial press and elsewhere.

In general these comments

suggest that local governments are unequal to the financial burdens
which they now carry or which may soon be imposed upon them.


it is a fact that most municipalities now are servicing their obligations
much better than at any time in recent years and currently the financial
condition of the obligors is good--at least when compared with the nine­
teen-thirties or even the nineteen-twenties.

Nevertheless, there is a

sense of uneasiness about these credits; an uneasiness which stems from
an acute consciousness of the many financial uncertainties which becloud
the future.

Whether communities will attempt to assume impossible

burdens because of the public demands, and thereby inpur financial dis­
aster, or whether new devices and arrangements will be developed to solve
or alleviate existing problems is open to question.
The flood of new securities floated by States and minor politi­
cal subdivisions has been another factor which attracted the interest of
bank supervisory authorities to this segment of bank assets.
number of reasons the volume has climbed to record levels.

For a
That in it­

self has been sufficient to arouse comment and stimulate concern.


more, reports of examinations reveal that a substantial amount of the new
flotations soon find lodgment in banks.
Now seems an appropriate time to review some of the background
information with respect to municipal securities.

The purpose of this

review is to establish some benchmarks which may be employed in Judging
the current situation as well as in attempting to forecast changes.

Recent Shifts in the Ownership of Municipals

Banks are playing a far more important role in the financing of
States and minor political subdivisions today than they did 10 years ago.
As shown in the accompanying chart, commercial banks now hold about 30$ of



1937 1938 1939 1940 1941 (942 1943 1944 1945 1946 1947 1948

- 3 tho outstanding securities whereas in
for only



their holdings accounted

of the total.

Tax considerations would appear to he paramount in account­
ing for the growing importance of commercial hanks as holders of mu­
nicipal securities.

Unlike most other corporations, hanks secure the

hulk of their income in the form of interest payments.


thoy enjoy a very real advantage when their resources are committed to
investments which are tax exempt.

Prior to 19^0, Federal securities

were used to a rather considerable extent in avoiding taxes and, of
course, tax rates were substantially lower than thoy are today.


ever, the opportunity to secure tax exempt income from Fédérais virtu­
ally disappeared in the early

19^0 's

and hanks turned to municipals

for this advantage.
Despite the talk about the advantages of tax exempt securi­
ties for individuals subject to the extremely high income tax rates
such holders have not even been maintaining their relative position
in this area of investments.

About four-fifths of the decline in the

dollar amount of securities making up the segment of the chart identi­
fied by the legend "Individuals, All Other Corporations and Associa­
tions," is attributable to the portfolios of individuals.

The corpo­

rations and associations included in this category, mostly institu­
tions whose income is derived primarily from tho sale of products or
services rather than investment of funds, have only a very small com­
mitment in municipal securities.
Shrinkage in the relative amount of municipals owned by in­
surance companies and mutual savings banks is readily explainable in


terms of tax considerations.



For all practical purposes, the investment

funds of these institutions are not subject to Federal income taxes.
Hence the alternative investment opportunities afforded by taxable se­
curities are far more attractive.

High grade industrial, rail or public

utility issues of comparable quality have a yield advantage of almost
one percentage point over the return on municipals.
From the viewpoint of bank examination and supervision, the
remarkable changes in the relative importance of banks as owners of mu­
nicipal securities is a matter of considerable significance.

The change

leads one to believe that the banking system is going to bear the brunt
of untoward developments in the field of municipal finance, when and if
they occur.

Very little imagination is needed to anticipate the pres­

sure which will be imposed upon the banks by the municipal obligors.
In fiction bankers aro cruel and relentless creditors--and
some may bo on occasion.

But what can banks do when defaults occur on

municipal securities in the portfolio?

Isolated individuals were never

conspicuously successful in dealing with municipalities at such times-and banks would be in oven a poorer position.

They will be depicted as

rich corporations well able to absorb some losses of‘principal and in­
terest, not widows and orphans relying on smhll investments for a liv­

At best, they would be obliged to accept disadvantageous changes

in the terns of the credits.

More than likely they would also be called

upon to make further advances.
All of these considerations suggest the importance both from
the viewpoint of bank supervisory authorities and bank management of

- 5 deviating as little as possible from sound investment principles in
connection with bank holdings of municipals.
be placed upon quality.

Enphasis as usual should

This is certainly no time for banks or super­

visors to experiment with marginal and substandard issues irrespective
of the fact that times are good and such securities temporarily enjoy
a fair reputation.

Nor should the importance of the maturity distribu­

tion be forgotten.

By a judicious selection of serial issues banks

may place themselves in an excellent position to revise their judg­
ments of individual municipal credits as securities mature in the
course of tho next few years.

Dollar Amount and Relative Importance of Municipals in
Bank Portfolios

To be sure banks are relatively more important as owners of
municipals today than they were a few years ago, but the supervisory
authorities should not act as if the solvency of the banking system
hinged upon tho credit status of States and the minor political sub­

For points of reference, the following chart has been pre­

pared which shows the book value of municipal portfolios held by tho
insured commercial banks and also the percentage of total assets in­
vested in municipal securities.
Over the period 193^-^8, municipal bond portfolios in
insured commercial banks have more than doubled in size.

But in the

•course of this same poriod, municipals have declined from a level of
about 5$ of total assots in the mid-1930's to about

in the mid-

Since then tho increase has been rapid but even now it has

only reached the 3


The decline in tho relative importance of

those securities resulted almost entirely from the growth in the total
assets of banks during tho war.
Only in the early war years, i.e. 19^2 and 19^+3 was there a
declino in the dollar amount of the municipal portfolio held by insured
commercial banks.

Now offerings of municipal securities wore practi­

cally at a standstill in these years and banks wore under tremendous
pressure to accumulate Federal securities.

Taken as a whole, tho trond

in tho municipal portfolio has been in tho general direction of a dollar
Notwithstanding the rapid growth in the dollar amount of mu­
nicipal obligations held by insured commercial banks, it would be reason­
able to anticipate a sizable future expansion in this portfolio.


ing that the banks were to invest 5$ of their total assets in these se­
curities, the proportion which typified tho prewar period, this would
entail further substantial additions to the portfolio unless total
assets wore to shrink materially.

Accordingly, rather than view the

present municipal portfolio for commercial banks as high, it would seem
moro reasonable to consider the figure rather moderate and to expect an
addition over the next few years that would bo in the* order of two or
three billions.

Recent Trends in the Volume and Character of
Municipal Flotations

Even a cursory view of the chart showing the volume of new
State and municipal bond issues is sufficient to emphasize one of tho
major causes for tho concern about bank portfolios of municipal securi­

In 191*8 the total amount of flotations was almost three times as



193 $













1948 es t .




















- 7 groat as the average for the prewar years.

With this amount of now se­

curities coning into the market, it is not at all surprising that bonk
portfolios grow in size.
Information regarding the composition of now municipal flota­
tions is not particularly satisfactory.

However, the available data

reveal that refunding operations were of considerable importance during
tho mid- 1930’s when tho tragedies of the acute depression years were
being corrected.

Again, refunding contributed importantly to new

financing during tho war years.

At that timo, issuers were able to

take advantage of progressively lower rates of interest by such

In the past two years, refunding has not been an impor­

tant contributor to municipal flotations, in part becauso terms for
refunding are no longer advantageous, and in part because tho current
finances of issuers are in reasonably good shape.
The volume of flotations for the purpose of financing relief
expenditures is indicative of the changing times.
declined from a high of
$100 million by 1937.


million in


Those flotations

to a level of less than

Curiously enough, as late as


there still

was a small amount of securities in this category, but it is doubtful
that any significance should be attached to tho figures subsequent to
Veterans Aid issues have been an important contributor to the
total amount of new municipal flotations since the end of the war.
This already aggregates almost a billion and a half dollars, and proba­
bly in the end will total substantially more than $2 billion.





bond offerings for this purpose are bound to disappear soon.
lifted the total amount of new issues for



and. 19^8 but even when

the total amount of Veterans Aid is eliminated the figure is still large.
Flotations of securities to finance local housing projects
thus far have never accounted for a largo portion of the total amount
of Stato and municipal bond offerings.

Considering the amount of dis­

cussion with respect to public housing, it is reasonable to suppose
that eventually such issues will appear in tremendous volume.


ventures always require large capital investments and this area of mu­
nicipal financing could easily take some turn which would present seri­
ous problems to the banks as well as the bank supervisory authorities.
Issues of State and municipal bonds to finance so-called
revenue projects have grown very rapidly.

A study of the chart shows

that financing of this type got well under way in the late 1930's.


war years dampened but did not eliminate the financing, and since the
war the volume is next to Veterans Aid in importance.
Because revenue issues are definitely crowding the market,
it is not hard to account for the widespread interest in this type of

Heretofore the traditional political subdivisions have been

able to finance the capital improvements needed to render the types of
service demanded by the citizens.

As the variety and costliness of the

services increases, however, the municipalities are obliged to adopt
various expedients.

Thus, community facilities requiring heavy capital

investments and on the border of customary State and municipal activi­
ties are financed on a soIf-liquidating basis through the creation of
what amounts to ancillary quasi-municipal corporations.




Originally revenue issues were only used to finance the well
established utility services such as water, electricity, gas, sewer,
and the like.

More recently there has been a rash of financing in the

form of revenue securities for the construction of toll bridges and
toll roads.

But in addition to these projects, there are now a host

of other ventures of one sort or another ranging from amusement fa­
cilities to public buildings financed by revenue bond issues.
Insofar as revenue bond issues are part of an arrangement for
making the users of a municipal service pay for the benefits derived
therefrom, they possess considerable merit.

When operators of motor

vehicles demand such facilities as limited access, super highways, as
well as monstrously expensive bridges and tunnels, it is reasonable to
make them pay for the projects by tolls, motor fuel taxes or otherwise.
Citizens generally may derive some benefits from these costly facili­
ties but none that can be readily traced.

Certainly it would be un­

reasonable to contend that the burden of these capital improvements
should be supported by the ordinary revenues of local governments, even
if that were possible.
On the other hand, revenue bond financing has been used to
facilitate the construction of projects which are clearly within the
scope of ordinary governmental activities.

For example, in seme

places public buildings, such as city halls, jailhouses, and schools
are financed by the issuance of so-called revenue bonds.

The reve­

nue in such instances takes the form of rental payments received from
the municipality using the facilities.

Proper service of the debt

depends upon the adequacy of these payments.

Fundamentally these

arrangements are subterfuges adopted because of weaknesses in local
finances, e.g. unusually low statutory debt limits or an antiquated
tax structure.
When minor political subdivisions in Kentucky, for example,
finance the construction of school buildings and jails by the issuance
of securities honorifically called revenue bonds the fact would appear
to bo evidence that all is not well in municipal finance.

If the minor

subdivisions of government are so weak that they cannot finance the
buildings necessary for their regular activities, the appropriate
remedy is not a revenue bond issue.

Rather the situation calls for

the strengthening of local government credit.

This may involve an over­

haul of tax machinery, an increase in the physical size of the politi­
cal subdivisions, or other drastic changes.
The chart of new municipal bond flotations raises some in­
teresting questions with regard to the future trend.
that the high level for




It could bo argued

is a temporary situation result­

ing largely from the Veterans Aid issues and the accumulated deficit of
financing during the war period.


You may recall that in the years 19^2-

it was practically impossible for municipalities to secure the

materials necessary to make normal public improvements.

According to

this view, the flotations will soon taper off and regress back to a
level between a billion and a billion and a half dollars annually.
More realistic, in my judgment, is the view that flotations cf
municipal securities will persist for years to come at levels above two

M i l l on.

A number of factors lend support to this view.

In the first

place, the bulk of the State and municipal bond flotations finance the
construction of more or less permanent facilities, and construction
costs are now high.

There are various answers to the question "How

high are building costs?" but most of the indexes agree that the
figures are about double the level of the 1930's.

Nor is there much

reason to believe that costs will soon decline to the prewar level.
High construction costs would help to sustain a high dollar volume of
municipal financing.
Other factors are contributing to the volume of municipal
security offerings.

The lack of public construction usually is

thought of as a wartime phenomenon.

As a matter of fact, it is a

phenomenon of both the war and the depression of the 1930's.

Few of

us realize that the proportion of school expenditures for capital out­
lays, mostly new buildings, in the two decades prior to the great de­
pression was about twice as high as the proportion in the 1930'a.


short, we now have an accumulated deficit of school construction ex­
tending over a period of 20 years, assuming that facilities were
reasonably adequate in the first three decades of this century,--and
that is a very dubious assumption.

Furthermore, population growth,

and particularly the expansion in the birth rate which has character­
ized the

19^0 's


will accentuate the burden on the existing school fa­

As yet the magnitude of the prospective needs for new school

buildings receives very little consideration by persons other than
careful students of the data.

To illustrate the problem, a 50$

increase in "the number of elementary school attendants is certain before


and increases may be greater.
As in the field of education, there are many other areas of

demand for municipal services involving capital investments which tend
to augment the pressure for new issues of securities.

Populations have

New roads and other community facilities will be needed to

serve both the old communities and the new ones better.

Taken alto­

gether.- those demands for capital additions will roach huge proportions.

The Trend in Municipal Yields

Study of the long term trends in yields on municipal securi­
ties emphasizes the great decline in the rate of return since the


A low point was recorded in the mid-19^0's &ud thereafter yields in­
creased but the amount was small.

To a considerable extent, of course,

the yields on municipals merely reflect the general trend of interest
rates on long term investments, but there is the important complica­
tion- -the feature of tax exemption.

These securities now are the only

haven of refuge for funds seeking to avoid the high income tax rates.
When Federáis lost practically all of their tax exemptions in the early

191*0 's,

the pressure of funds seeking this advantage was directed

towards municipal securities.
Banks are now subject to combined Federal tax rates ranging
from 21$ to 25$ on the blocks of taxable not income up to $25,000.


the next tax block, $25,000 to $50,000, the combined rate is 53$.


that bracket a


rate is applicable for all taxable income.


ingly, the tax saving value of municipal income depends upon the earn­
ings position of the individual bank.


- 13 Those peculiarities of the tax structure no doubt have a
definite influence on the decisions of portfolio managers with respect
to the attractiveness of yields on specific issues of securities.
turn, such decisions are reflected in market quotations.


A yield

basis attractive for an institution subject to the 53$ bracket might
be wholly unsatisfactory to banks in the lower tax brackets.


cursory chock of the data leads one to the conclusion that quotations
for municipal securities tend to discount more or loss fully the tax
exemption to holders in the 38$ bracket.

Institutions subject to that

rate are probably the dominant market factor.

To seme extent, how­

ever, the extremely high rates applicable to individuals cloud these
yield relationships.
Unquestionably the feature of tax exemption has been a
powerful factor bearing upon the yields of municipal securities, and
as shown by the accompanying chart, the level currently is low.


fact should never be forgotten in any discussion of bank portfolios.
The return on these securities just cannot provide much of a cushion
to absorb losses of principal.

As a consequence, the need for quality

in municipal portfolios is great indeed.

With other types of invest­

ments maybe banks can afford to make a few mistakes because the earn­
ing power of these assets is relatively high.

But anyone who thinks

that income from interest coupons of 1$ or 2$--even if they are tax
free--will accumulate money enough to absorb a sizable loss of for ex­


or 20$ in any reasonable length of time is badly mistaken.

Ik V.

Rules and Guides for Municipal Portfolios

The foregoing review of the essential facts with respect to
the bank holdings of municipals and prospective trends in this area of
finance suggests that in the future the municipal portfolio in banks is
likely to present a series of very troublesome problems both to banks
and supervisors.
Over-sized portfolios will be acquired by a few banks.

As a

consequence difficulties when they arise with respect to quality,
marketability or maturity will be far more serious for such institu­
tions than for others with a reasonable amount of these securities.
Most certainly the. sales pressure by the security dealers who will be
called upon to distribute the prospective volume of new flotations
will be much greater than in former years.

Bankers probably will be

persuaded to buy issues which are not entirely suited to their needs.
Efforts by security distributors to force banks and bank supervisors to
accept lower standards of quality are always discernible but they now
seem to be growing more vigorous.
When issuers experience financial difficulties the interested
banks will be involved in a whole new complex of problems.

More than

ever before the banks, as such, will bo identified as principal credit­

In this role they will be subject to all of the pressures that

arise in salvage operations:

the business of sending good money after

Banks and bank supervisors will be well advised to view the

present trends carefully.

By an appropriate course of action it may be

possible to avoid or alleviato problems before the evil days arrive.

- 15 Actually there are not nany principles for the guidance of
bank supervisory authorities in dealing with securities, but there is
one which is simple and sound:
for an asset of poor quality.

There is no place in a bank portfolio
That principal, I know, is honored in

the breach as well as in the observance, but in my judgment, when the
supervisory authorities compromise on quality, they should recognize the
compromise as a misfortune that attends administrative activities in a
rather imperfect world.

The elimination of poor quality assets should

always be a major objective.
When business is prosperous and markets are strong the time
is appropriate to clean up a municipal bond portfolio, or for that
matter any assortment of assets.

Occasionally I note in our files an

exchange of correspondence between supervisory authorities and bank of­
ficers indicating that an institution has sold a block of securities
classified as borderline or substandard in quality.

Those cases usually

follow a pattern and the next step is an assertion by the bank officials
that the securities wore sold at a substantial profit.


correspondence in such files sometimes indicates that the bankers have
attempted to embarrass supervisory authorities by calling attention to
the fact that prices for these securities subsequently climbed even

In my judgment, this is an illustration of very sound supervi­

sion, because a banker who succeeds in cleaning up the weak spots in
his municipal portfolio at a profit is indeed fortunate.

The fact that

he might have sold the securities on oven more profitable terns is of
small concern to me or anyone who looks at the matter objectively.


real question and the one which is seldom answered in the correspon­
dence is this:

"What did the banker do with the money which ho freed

from his substandard investment at a profit?"

Assuming he is at all

competent, he should havo been able to employ these funds in a sound
fashion and with somo return for his trouble.
The maturity distribution of a municipal bond portfolio needs
careful scrutiny at the present time.

Banks who bought the 25 and 30

year maturities with 1% coupons two or three years ago have learned by
rather painful examples that a mathematical relationship obtains between
coupon, yield and maturity irrespective of the question of quality.


bo sure, banks with a few of these bonds, and prospects for reasonably
stable deposits, need not be concerned about discounts from book value
of 20-30 points.

But that is only true for institutions with a rela­

tively small portion of thoir portfolio in extremely long maturities.
A systematic plan for spacing maturities over a term of years, e.g. 10


enables an institution to average its rate of return for the

period and to be comparatively free from problems attending fluctuations
in market prices.
Customs of financing in connection with the issuance of State
and municipal bonds havo firmly established the practice of serial ma­
turities .

Even at the expense of boring reiteration, it is well to in­

sist that the managers of municipal portfolios take advantage of the
serial feature.

Anyone who knows anything at all about the market for

municipal securities knows that it is a distinctly poor one in terms of

Every transaction involves negotiations»

The blocks change

hands in relatively largo amounts.

When a bank attempts to buy or sell

loss than five bonds, the transaction is treated as an odd lot with
prices even further away from the prevailing quotations.


the area of investment for individual issues is surprisingly narrow
because the number of issues is great and the dissemination of invest­
ment knowledge in a groat many cases is almost literally pedestrian in

As you know, only the larger communities have issues that

enjoy a situation that remotely resembles a nationwide distribution.
Largely because of the increased volume of municipal flotations
as well as the rise of novel types of issues such as the revenue
securities, the methods and principles for municipal credit analysis
are coming up for discussion.

It is my judgment that neither

bankers nor bank supervisory authorities need to be alarmed about
the prospects for a revolution in the techniques of municipal se­
curity analysis.

Now, as ever, the top grade of issues will always

stand out vory conspicuously.

Troubles there will be in judging

quality if the issue deteriorates.

Most of the difficulties will

likely be encountered in connection with the borderline cases.


supervisory authorities and the bankers would be well advised to

the effort to make nice distinctions between the securities

which are competing for place on the marginal or substandard list.
To bo sure, issuers of such securities need a market.

So far as I

am concerned, they may be sold wherever the distributors find a
customer, but only providing the salesmen stay away from banks.



Comment in the financial press recently has noted that changes
in the composition of municipal revenues as well as changes in character
of the services required from these governmental units tend to render
unsatisfactory the old ratio tests of credit quality.

Usually discus­

sions of this sort inveigh against the use of the time honored debt
ratio (the amount of debt expressed as a percentage of property valua­
tions for tax purposos) as a criterion.

It has been my observation that

the attempt to judge municipal credit on the basis of a ratio, or even a
series of ratios, not only is unsound today, but it probably never was
In judging credit quality, the past history of the community
and its current economic resources has a place in the process.


total amount of debt outstanding and the character and composition of
the revenue and expenditures are important facts.

As a matter of fact,

tho debt ratio test becomes progressively less meaningful with the rise
in the importance of revenue sources other than tho ad valorem taxes.
But the analyst of municipal credits is not limited to any standard
pattern in his work.

For example debt service requirements expressed as

a percentage of tho total amount, of expenditures is a good measure to
employ when tho debt ratio

is of limited usefulness.

In analyzing

credit quality, every bit of pertinent information at hand should be so
marshalled that it contributes as much as possible to the understanding
of tho crodit.

- 19 Conclusion
The foregoing discussion sought to present in orderly fashion
the major pieces of background information with respect to bank invest­
ment in municipal securities.

Facets of the investment problem are

many and varied, however, and a complete study is far beyond the scope
of this brief discussion.
While it would bo extremely difficult to maintain the propo­
sition that weakness in municipal securities may jeopardize the sound­
ness of our bonking system, the figures do indicate that acute problems
may develop for individual banks.

The rapid growth in the total amount

of these portfolios as well as the sharp increase in their relative im­
portance leaves ono with the feeling that some institutions may very
well acquire portfolios which are wholly out of balance.

Such institu­

tions with excessive holdings of municipals, marginal and substandard ~
issues or poorly solected maturities, could easily got into trouble.
Supervisory authorities should be searching for these institutions,
and appropriate remedial measures adopted when the cases are dis­
Banks certainly aro not now in a very good position to accept

Their capital margins are pitifully thin and earning power is

far from improssivo.

The growth trend over the years in the municipal

portfolio calls attention to a segment of assets wherein potential
losses may be accumulating.

Losses in this portfolio are going to bo

as unpalatable as losses elsewhere.

April 5. 19^9