Loss of Tax-Exempt Status Could Hurt Banks With Muni Exposure

If a fiscal cliff deal trims deductibility of munis, banks that bought the bonds at high prices stand to take a big hit

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Meredith Whitney’s warnings about a wave of municipal bankruptcies two years ago didn’t kill munis, nor did Orange County’s 1994 bankruptcy, but will ending their tax-exempt status push these securities, or at least those who own them, over the fiscal cliff?

It is not known what the White House and Republican leaders will ultimately decide in talks that have included the idea of limiting the tax-deductibility of municipal bond interest.

But a new report by SNL Securities suggests that such a move could potentially deal a blow to many banks that have increased their holdings of these bonds over the last three years in their quest for higher yield in a low-interest-rate environment.

Bank and thrift holdings of municipal securities have grown to more than 20% of assets from just over 15% only three years ago, SNL’s report shows. Wells Fargo tops the list of muni assets, with $38 billion in its portfolio. Adding in JPMorgan Chase, Citigroup and MetLife brings total muni exposure to $95 billion for the four banks that hold the most munis.

But these are all financial institutions whose large size and asset diversification could presumably cushion the hit to their portfolios. Far more is at stake for smaller financial institutions that have bet heavily on munis.

Indeed, SNL’s list includes two institutions – financial holding company Cass Information Systems and Depository Trust Co. – whose securities portfolio is 100% invested in munis.

Most prominent on the list of highly concentrated portfolios is First Republic Bank, a boutique bank targeting a high-net-worth clientele, 77% of whose securities consists of munis.

First Security Bancorp and Bank of the Ozarks, two large Arkansas banks, are also prominent holders of munis, with 97% and 84% of their portfolios, respectively.

One analysis cited by SNL states that munis stand to lose about 5% under one fiscal cliff plan currently under discussion, thus implying a limited impact, though potentially a more meaningful one for institutions that bought munis at higher prices.

Concludes SNL: “Any institution that purchased bonds shortly after the outflows in the municipal market slowed, or not long after that, likely is sitting on large gains that probably could even hold even if the tax-exempt status of muni-bonds changed and broad selling of the securities occurred. However, banks that built their muni-bond positions more recently could find themselves more exposed to losses if the tax-exempt status changed and the muni-bond market once again came under severe pressure.”

Muni bond values swooned following Meredith Whitney’s December 2010 doom-laden prediction about municipal bankruptcies, but they recovered starting in May 2011. SNL says banks that bought the securities during the four-month sell-off profited handsomely.

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