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Statement of
William W. Sherrill
Member, Board of Governors of the Federal Reserve System
before the
Subcommittee on Economic Progress
of the
Joint Economic Committee

July 10, 1963

In response to your invitation, I would like to discuss four
major points:
1.

The importance of commercial banks as investors

in State and local obligations;
2.

The impact of varying credit conditions on State

and local finance;
3.

What can be done to lessen the sensitivity of

this sector to changing credit conditions and generally
improve the market for these obligations, and
4.

The influence of bank examinations and bond

ratings on bank participation in the tax-exempt market.

COMMERCIAL BANKS AS A SOURCE OF FUNDS FOR STATE AND LOCAL SECURITIES
Among all the major financial institutions, commercial banks
have the greatest incentive to acquire tax-exempt State and local bonds.
Taking the entire period since the end of World War II, commercial banks
have been the major provider of credit to State and local governments,
acquiring about 45 per cent of the net increase in such obligations.
The most rapid increase in bank holdings of State and local bonds has
occurred since 1960.

In part this acceleration was due to enlarged time

and savings deposit inflows and a generally stimulative monetary policy




-

through most of the period.

2-

It reflected also the fact that such

securities constituted one of the more profitable uses during this
period when business loan demands were relatively modest.
From the end of 1960 to the end of 1965 banks allocated about
20 per cent of the growth in their earning assets to tax-exempt issues.
Commercial banks increased their holdings of State and local obligations
from 8 per cent to 12.5 per cent of their total loans and investments,
and the share of all outstanding municipal bonds in bank portfolios rose
from 25.5 per cent to 38 per cent over these years.
During the five-year period, 1961 through 1965, commercial banks
financed well over two-thirds of the net increase in State and local
government obligations.

But as business and other bank customers stepped

up their credit demands in 1966--and monetary policy became more restrictive--banks cut back their rate of acquisitions of municipal bonds,
acquiring an amount equal to about 40 per cent of new issues.

In 1967,

as loan demands eased and monetary policy became more expansive, banks
again accelerated their purchases of State and local securities, acquiring
an amount equal to over 80 per cent of that year's new issues and
allocating one-fourth of their credit extensions to these securities.
Year-to-year variations in bank participation in the municipal
bond market, of course, reflect both the shifting demands made upon the
resources of commercial banks and changes in the availability of funds
to them.

Banks— like other lenders--make their investment decisions on

the basis of the available supply of funds and both long-and short-run
considerations of business strategy.

Normally they prefer loans, where there

is a long-run customer relationship, to investment in securities, where
there usually is not, particularly when their funds are in limited supply.



3-

Security investments are made partially to provide )>ools of
liquidity and partially for income.

i.hen the credit demands of loan

customers rise, banks move to accommodate these demands by adjusting
their security portfolios.

Thus, bank decisions to purchase and hold

tax-exempt bonds are but one component of their long-run investment
policy which must balance income and liquidity with service to, and
protection of, their depositors.

VULNERABILITY OF STATE AND LOCAL FINANCES TO CREDIT AVAILABILITY
State and local governments, along with other sectors of the
economy, have experienced higher costs of borrowing during the past
three years.

These higher yields have been required even while banks

were heavy purchasers of State and local bonds in 1967.

With large

volumes of new debt coming to market, issuers generally have had to
attract investors by raising yields.

The higher cost of borrowing

appears particularly onerous to State and local governments since they
finance about half of their capital outlays from the sale of bonds in
the capital markets.
The Federal Reserve System has undertaken studies of State
and local financing experience on several occasions to determine to
what degree public bodies are forced to alter their plans to borrow and
to spend because of changing credit conditions and interest rates.




-

4-

The most recent study focused on the year 1966 when credit
markets were experiencing a sustained escalation of rates*

While the

survey results are not fully tabulated for the over 12,000 smaller
governmental units that were contacted, they are completed for the
1,000 largest State and local governments.

I shall, therefore, focus

my remarks on these larger units.
Of the 983 large State and local units replying to the
survey, slightly over one-half stated that they had planned to borrow
long-term in 1966.

About three-fourths of these carried out their

plans fully as intended during that year.

The remainder, however,

altered cither the timing or the amount of their borrowings, and
5 per cent of all respondents completely canceled their long-term
borrowing plans for the year.

In dollar terms, long-term borrowings

were cutback or reduced by $1.4 billion, an amount equal to 22 per cent
of the $6.2 billion that large units actually borrowed in 1966.

About

80 per cent or $1.1 billion of the cutback were due primarily to
interest rate factors.
Although the effects of borrowing changes on expenditures
may stretch out through time, the very sizable cutback of long-term
borrowing did not have a large immediate impact on the capital spending
of large State and local governmental units.

In 1966, reduced or post­

poned contract awards and spending on projects already underway amounted
to only about $100 million.

Obviously, the bulk of the shortfalls in

long-term borrowing plans did not lead to reductions in contract awards
and spending.




In about half the cases where there was no impact on

-

5-

expenditures, governments had planned to borrow well in advance of
cash needs.

In most of the remaining cases, outlays were kept on

schedule by running down liquid asset reserves or by borrowing short*
term--usually from commercial banks.
We have not completed tabulations of the survey results for
the smaller local governmental units, so I can only give approximate
information regarding their financing experience.

Preliminary analysis

seems to indicate that about 360 of the 10,000 respondents abandoned
or postponed long-term borrowings that had been planned for 1966.
Approximately 170 of these units reduced or postponed their 1966
borrowings because of high interest costs.

In contrast to the experience

of the large units, however, over one-third of these units found it
necessary to cancel or reduce their contract awards in those instances
where high interest rates were at least a factor in the deferral of
long-term borrowing.

While these results are only tentative they do

seem to indicate a much lower degree of financial flexibility on the
part of these smaller units--fewer short-term alternatives are open to
them if their long-term financing plans go awry*

They either pay the

higher costs of borrowing long-term or they drop the project until
more favorable times*
While not minimizing the difficulties faced by individual
communities in canceling their construction plans, I do wish to point
to the fact that the vast majority of State and local governments,
both large and small, were able to go ahead as planned, either by
paying more for their long-term borrowings--as other borrowers were




6

required to do--or by borrowing short-term or by dipping into their
liquid assets.

Evidently, most were reasonably successful in adjusting

to financial pressures.

REDUCING THE VULNERABILITY OF STATE AND LOCAL FINANCES
With the 1966 borrowing survey as a background, let us
consider some of the actions State and local governments might take
to minimize the burdens of high interest rates and reduced credit
availability.
First, it is important to remember the basic purpose of
restrictive credit policies.

They are meant to curtail total spending

when limited resources are being sought too vigorously»

State and

local governments do not draw upon isolated pools of commodities and
services.

Each unit's demands must be added to those of private enter­

prise, the Federal Government, and other State and local governments.
Each competes for the bricks, mortar, and human skills that can build
houses or office buildings as well as schools and firehouses.

Thus,

it is necessary that some marginal public projects, as in other sectors,
be deferred or stretched out during periods of over-heating in the
general economy.
One way State and local governments can avoid being squeezed
in the financial markets is for them to pay for more expenditures out
of current receipts.

But these units, caught letveen pressing demands

for public facilities anc1 already heavy tax burdens, would find prolonged
pay-as-you-go financing of capital outlays exceedingly difficult.




-

7-

However, units might time borrowings and construction so
that they complement rather than compound the needs of other sectors
of the economy.

By the same token, many might consider the advantages

in the future of accelerating their capital outlay programs during
periods of economic slack to take double advantage of both lower
borrowing costs and the greater availability of construction resources.
Besides advantageously adjusting their demand for credit
and resources to the pressures of the rest of the economy, State and
local governments might also examine their own policies and institutions
for features which complicate their financing problems.

V' know that
•

in 1966 units met % ith delays and perhaps ultimately higher borrowing
’
costs because of interest rate limitations imposed upon them by their
own constitutions or legislatures.

Rigid interest rate ceilings are

but one of many legal obstacles which pervade the organization of State
and local governments.

Debt and property tax limits which are overly

restrictive either have suspended needed public improvements or have
been avoided through the use of expensive alternative forms of financing
such as the revenue bond.

State governments when strapped by limitations

on their indebtedness that have become outmoded often must pass the
burden of borrowing onto their subdivisions, where it tends to be less
secure and therefore more costly.
Evidence indicates that borrowing costs are higher for
smaller units, partially because they borrow in small amounts which
are uneconomical to offer in the national market.

While measures may

be taken to improve the competitive position of these small issues,
they still represent a low volume, high cost per unit, form of borrowing.




-

8-

Some State governments have seen fit to lend credit
assistance to their local units by giving direct loans, guaranteeing
local borrowings, or through extending grants to help defray debt
service.

Others have made efforts to oversee their subdivisions'

borrowing programs and to lend technical advice, thereby improving the
marketability of local obligations.

Many States, aware that excessive

.diffusion of local government responsibility and resources can be
uneconomical in ways other than the cost of borrowing, are encouraging
consolidation of and cooperation among local governments.
None of these efforts, which State and local governments
might accomplish for themselves, will insulate theci from the burdens
of competing for limited funds in times of financial strain.

But

such measures could help in marshaling their energies and resources
to plan ahead for and successfully cope with such times.
The Federal Goverruaent might also assist in alleviating State
and local borrowing difficulties.

For example, legislation to permit

commercial bank underwriting of revenue bonds could improve the
competition in the municipal bond market and might lower slightly the
borrowing costs of such issues.

Such legislation is supported by the

Board of Governors,as Governor Mitchell testified before the Senate
Subcommittee on Financial Institutions last August.
Borrowing costs on municipal bonds are already much lower
than they otherwise would be because of the exemption of their interest
_. T
_
I

>

from Federal incoaM^£$esV.vi^is feature makes these securities most

jr/
i

attractive to thora investors -in the higher tax brackets--like high




. ,v

-

9-

income individuals, as well as to the more heavily taxed financial
institutions, such as commercial banks and fire and casualty insurance
companies*

Thus State and local governments do not have to compete

on the same basis with other issuers of debt obligations, the interest
income from which is fully taxable.
This implicit subsidy given to State and local governments
has been less of a boon to these governments in recent years as the
volume of new tax-exempt issues has exceeded the volume of funds
available from investors in the highest tax brackets.

In order, there­

fore, to attract additional investors to municipal bonds, tax-exempt
yields have had to rise relative to yields on taxable securities to a
point that makes them attractive to investors in lower and lower
marginal tax brackets.

For example, over the last decade it appears

that investors in marginal tax brackets between 20 per cent and 30 per
cent have had to be drawn into this market in order to meet the demands
for funds by State and local governments.
Calculations by the U. S. Treasury and others indicate that
the tax revenues foregone because of the present tax-exemption of the
interest income of State and local obligations considerably exceed'
the interest cost savings enjoyed by these units.

This has prompted

suggestions that the interest income from municipal bonds be made fully
taxable.

Since such obligations no doubt would carry higher yields

than is today the case, it has been suggested further that the increase
in the cost of borrowing be offset by a subsidy from the Federal
government.




The extent to which such a subsidy plan might lower the

-

10-

net cost of borrowing for State and local governments and increase
the revenues of the Treasury depends directly on its design.

And it

must be recognized that the demands of investors in particular are
fluid and that their portfolios are flexible as they pursue their
investment objectives.

Therefore, any calculation of future tax

revenues gained and subsidy payments needed if State and local securities
were to be made taxable depends on a wide range of variables including
the way in which markets adjust ultimately to the changed capital market
environment.
Bills recently introduced by Representative Patman, H.R. 15991,
and Senator Proxmire, S. 3170, propose that the Federal government
subsidize 33 per cent of the interest cost on State and local obligations
that voluntarily give up their tax-exempt status.

Issuing governments

would therefore be free to choose between issuing their securities on a
tax-exempt basis as they now do, or issuing them on a taxable basis
and receiving the subsidy.

Governments will choose the alternative that

is cheapest for them after comparing the interest cost of issuing their
securities under the two alternatives.

Clearly, if the cost of

borrowing in the taxable market is more than half again that of
borrowing in the tax-exempt market, they will find it most economical
on a net-cost basis to borrow in the former and forget the subsidy.

On

the other hand, should the ratio of the tax-exempt to taxable bond yields
rise above .67, governments will find it less expensive to issue taxable
bonds and take the subsidy.




-

11-

Those investors above approximately a 33 per cent marginal
income tax bracket would still find it advantageous to hold tax-exempt
bonds so long as the ratio of yields on tax-exempts to alternative
taxable securities remains at or above .67.

On an after-tax basis

they will be earning more on the tax-free income than if they had
invested an equivalent amount in similar obligations the interest income
of which is taxable.
Generally speaking, the ratio of yields on tax-exempt and
taxable bonds in the market will depend on the demand for and supply
of existing stocks of obligations.

The change in the stock of tax-

exempt bonds will be determined in part by the decisions of the issuing
authorities between tax-exempt and taxable securities.

As long as the

total outstanding stock of tax-exempts exceeds the holdings desired
by investors in the greater than 33 per cent marginal tax-bracket, the
ratio of yields will exceed .67.

But over time there will be a down­

ward pressure on the ratio of yields.

Communities will issue taxable

securities and take Che subsidy, and investors will bid up the prices
for outstanding tax-exempt bonds as the supply of new tax-exempt issues
tapers off.

The ratio of tax-exempt to taxable yields will most likely

tend to settle down to approximately .67.

This is a problem in dynamic

adjustment— it would take time to work itself out and just how long it
would take, I do not know.
Channeling all or part of the new issues of State and local
obligations into the taxable bond market will of course broaden the
range of investor groups potentially attracted to State and local




-

obligations*

12-

However, it is not uithout cost in terms of the subsidy

paid by the Federal government.

And it should be realized that additional

Federal income tax revenues caused by investors shifting into taxable
assets might not meet the full cost of such a subsidy, no matter what
the extent of its use.
Taking the 33 per cent subsidy plan, as I have just mentioned,
investors in the greater than 33 per cent marginal income tax bracket
probably will stay in the tax-exempt market.

Most investors below that

tax bracket--as the ratio of tax-exempt to taxable bond yields falls—
will shift into taxable investments.

But the additional tax payments

they make to the Treasury would tend to return less than the added
expense of the 33 per cent subsidy.

That is, it will cost 33 cents for

every dollar's worth of investment income shifted into a taxable
category; but the investors most likely to make such a shift will be
those who on the average pay less than 33 cents in taxes on each additional
dollar of interest income.
Another proposed form of Federal government assistance is
the guaranteeing of debt service on State and local obligations to be
financed by insurance fees.

Such a proposal would virtually eliminate

the default risk to investors on insured obligations, make them homogeneous
in terms of investment quality (thus eliminating the need for individual
bond ratings for such securities), and would enhance their marketability.
These may be desirable objectives, but they are not costless.

Fees must

be collected to provide for the contingency that fome issues may default.
If the insurance fees are proportionately the same for all issues




-

13-

irrespective of their intrinsic quality, then this implies that
governments with relatively stronger credit positions will, in part,
carry those with weaker credit standing.

And the Federal government

would be assuming a large contingent liability, to the extent that the
fund built up by the fees does not grow as rapidly as the liability.
It is not clear what the value of such a guarantee would be
to issuers.

The experience of Public Housing Authority Obligations

indicates that such a Federal guarantee reduces the yield demanded by
investors by perhaps 20 basis points on the average.

Whether this

would still be the benefit for guaranteed securities is problematic.
Smaller and lower or unrated issues would probably be benefited the
most.

However, it should be pointed out in passing that increasing the

supply of Federally guaranteed issues would no doubt expand the
competition for funds for certain forms of Federal borrowing, thus
tending to increase their interest costs.
As in the proposals of Representative Patman and Senator Proxmire,
interest subsidies and guarantees could be used in tandem.

The ultimate

cost and benefits of a combined program depends jointly on how such
securities are accepted into investor portfolios as well as on the
extent of their utilization by governmental units.

I cannot predict

with certainty what the final outcome would be.
But on balance, it appears that the current proposals would
not constitute a revenue bonanza for the Treasury.

Indeed, they probably

would entail a net cost to the Federal government, both through the
cost of the subsidies as well as in higher direct borrowing costs, since




-14

guaranteed taxable State and local obligations would be more competitive
with U. S. Governments and Agency issues.

Such a program of Federal

assistance most likely would lower the costs of borrowing for State
and local governments, both through direct payment of the subsidy,
and indirectly by relieving the volume of borrowing in the tax-exempt
market.

But it is not at all clear to me that the benefits for the

State and local units would be as large as the costs to the Federal
government.




-

15-

BANK EXAMINATIONS AND COMMERCIAL BANK HOLDINGS OF STATE AND LOCAL
OBLIGATIONS
Mr. Chairman, in concluding this statement I would like to
make a few remarks on bank examinations and their effect on the
portfolios of the smaller commercial banks.
The broad objective of bank supervision is the maintenance
of a sound banking system.

An important part of bank supervision is

the examination of bank portfolios which are undertaken for the purpose
of protecting the individual depositors and the banking system at large
from unwise extensions of credit.

In the course of these examinations

of loan and investment portfolios, the regulatory agencies are concerned
with appraising the general solvency of bank earning assets, including
the obligations of State and local units, and not with rating the quality
of particular issues.

Banks are asked to stand ready to review their

reasons for selection of specific holdings if there is any doubt of
their credit worthiness--regardless of any bond rating.
The information needed to document the credit worthiness of
a particular bond issue— relating to such factors as taxes and receipts,
trends in outstanding debt, tax base,and population— are matters of
public record and are readily available.

It is the type of information

basic to the bank's having made an informed and rational investment in
the first place.

It is the type of information always given in bond

prospectuses, and is generally available from dealers selling bonds to
the bank.

Additionally, many of the holdings of the smaller banks are

the obligations of their own local governments or those of the surrounding
communities, whose finances they should know well.




-

16-

It is possible, as has been suggested, that factual data
reports prepared by a Federal agency might be useful to investors and,
therefore, might improve the marketability of very small issues.
we feel that much of

But

this data used in reaching investment judgments

are already available to prospective investors.
It has been the experience of our examiners that the number
of cases where bank holdings of State and local obligations have been
criticized--whether they have been nationally rated or not--has been
infinitesimal.

According to the latest data we have (for 1966) less

than .01 per cent--one ten thousandth--of the total dollar amount of
member bank "other security" holdings (made up predominately of municipal
bonds) were classified as being below investment quality.
I think that the best evidence that examination procedures
and quality of investment requirements have not deterred commercial
banks from investing in State and local obligations, especially those
of a small and unrated nature, is found in the magnitude of their holdings
of these securities.

In this respect, the results of a recent survey

of the State and local obligations held by insured nonmember banks during
the period 1960-1964 are helpful.

These banks are regularly examined

by the FDIC using procedures which, under the various uniform examination
agreements, are the same as those employed by the Federal Reserve and
the Comptroller of the Currency.

We have no reason to believe that

results for member banks would be substantially different.
The point I wish to call to your attention is that on average
these banks held a high percentage— about 30 per cent— of their State




17-

«»

and local obligations in the unrated category.

At the outside, during

the 5-year period 1957 through 1962 unrated bonds accounted for about
1/3 to 1/4 of the dollar volume of all tax-exempt issues--general
obligations and revenues.

Moreover, the smaller the bank, the higher,

on the average, was its percentage holdings of the unrated issues.
Holdings in the unrated category amounted to well over 1/2 of all State
and local issues for banks with deposits of less than $5 million.

This

seems to indicate that far from being regulated away from the unrated
market, smaller banks have taken a very strong interest in these
securities.
This, of course, is to be expected.

The local bank is aware

of local needs and conditions and its stake in the community.

It is

the traditional source of credit for small borrowers, both private
and public.




-

18-

COMMERCIAL BANK PARTICIPATION IN MARKET FOR STATE AND LOCAL
GOVERNMENT OBLIGATIONS

Change in
Commercial Bank Holdings
Of S&L Government Oblisations
Net Change
A % of Total
($ billions)
Net Issue

Year

Level of
Commercial Bank Holdings
Of S&L Government Obligations
As % of Total
Level
Outstanding..
($ billions)

1950

1.6

59.2

8.1

32.8

1951
1952
1953
1954
1955

1.1
1.0
0.6
1.8
0.1

57.8
38.4
16.2
4.1
3.1

9.2
10.2
10.8
12.6
12.7

33.8
34.1
31.6
31.8
28.3

1956
1957
1958
1959
1960

0.2
1.0
2.6
0.4
0.6

6.7
22.7
30.0
8.9
16.7

12.9
13.9
16.5
17.0
17.6

26.1
25.8
28.1
26.7
25.6

1961
1962
1963
1964
1965

2.8
4.4
5.2
3.6
5.1

57.1
88.0
77.6
59.3
67.6

20.3
24.8
30.0
33.5
38.6

26.9
30.0
34.1
35.7
38.5

1966
1967

2.4
8.5

40.0
82.5

41.0
49.5

39.2
42.2

Source:

Board of Governors, Federal Reserve System.







-

19-

YIELDS ON COMPARABLE MUNICIPAL AND CORPORATE
BONDS AND MARGINAL INCOME TAX RATE GIVING
EQUIVALENT AFTER-TAX YIELDS
1950-67

Year

1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
*
**

Annual Average Yield*
Municipal
Corporate
Bonds
Bonds
m
_
(IV
1.56
1.61
1.80
2.31
2.04
2.18
2.51
3.10
2.92
3.35
3.26
3.27
3.03
3.06
3.09
3.16
3.67
3.74

2.62
2.86
2.96
3.20
2.90
3.06
3.36
3.89
3.79
4.38
4.41
4.35
4.33
4.26
4.40
4.49
5.13
5.51

Equivalent**
Yield Tax
Bracket
1 - /~m/(2> 7
40
44
39
28
30
29
25
20
23
24
26
25
30
28
30
30
28
32

Moody's Investor Service, Aaa, long-term bonds.
Investors in the calculated marginal income tax bracket earn
the same after-tax yield on municipal and corporate bonds of
comparable quality.

20ANNUAL AVERAGE INTEREST RATE SPREADS BETWEEN PUBLIC HOUSING AUTHORITY
AND MUNICIPAL OBLIGATIONS
(Per cent)

(1)
33-40 year
PHA Obligations

(2)
30 year "Good
Grade" Municipal

(2) - (1)
Interest Rate Spread

1962

3.18

3.42

0.24

1963

3.11

3.36

0.25

1964

3.33

3.48

0.15

1965

3.31

3.45

0.14

1966

3.74

3.99

0.25

1967

3.89

4.15

0.26

Total*

3.45

3.66

0.21

* Figure is the averaging all observations of given issues.
SOURCE: U.S. Department of Housing and Urban Development; Salomon Brothers &
Hutzler, An Analytical Record of Yields and Yield Scales. Part II.




-21

HOLDINGS OF STATE AMD LOCAL GOVERNMENT OBLIGATIONS BY INSURED
NON-MEMBER COMMERCIAL BANKS EXAMINED IN 1964, ANALYZED BY SIZE OF BANK

Size of Banks By
Total Assets
($ millions)

Total Holdings of State
And Local Government Obligations
($ millions)

Holdings of Unrated
Issues As A Percent Of
Total Holdings
(Per Cent)

11

63.8

1 to 2

89

61.8

2 to 5

559

50.8

5 to 10

848

36.7

Over 10

2,502

18.8

All sizes

4,009

28.1

Under

1

HOLDINGS OF UNRATED OBLIGATIONS AS A PERCENTAGE OF TOTAL HOLDINGS
OF STATE AND LOCAL GOVERNMENT ISSUES BY INSURED NON-MEMBER COMMERCIAL
BANKS EXAMINED 1960-1964*

Total Holdings of State and Local
Year

Government Obligations
($ millions)

Holdings of Unrated Issues
As A Percent Of Total
Holdings
(Per Cent )

1960

31.7

1961

2,912

31.5

1962

3,158

30.3

1963

3,466

29.2

1964

*

2,881

4,009

28.1

Both tables based on tabulations from Federal Deposit Insurance Corporation
examination reports.