Latest Federal Reserve Data Offers a Glimpse Into Bank Bonds

Recent data from the Federal Reserve suggest what market participants have suspected for months - that banks have fewer floating interest-rate bonds on their balance sheets because investors are growing more confident holding variable-rate debt.

Data for July in the Fed's recently released Monthly Report on Credit and Liquidity Programs and the Balance Sheet show that the dollar amount of municipal bonds banks pledged to the Fed as collateral for loans from the discount window has declined by about 20% since May.

The banks include liquidity providers, which grant letters of credit and standby bond purchase agreements to issuers, as well as banks funding inventories or proprietary positions. The data suggest the banks may not need as much Fed credit to redeem floating-rate bonds from investors and that risk-aversion stemming from the credit crisis last fall has gradually abated, sources said.

"This is another sign of progress," Matt Fabian, managing director at Municipal Markets Advisors, wrote in its weekly outlook sent to clients on Monday. The falling loan balances imply variable-rate investors are easing back into the market and "are growing more adventurous in what they purchase and trade," he said.

As of July 29, banks with access to the Fed's discount window posted $29 billion in municipal bonds as collateral. The dollar amount included a partial discount, or haircut, that the Fed required for credit risk associated with the securities. Treasuries posted to the Fed have no haircut.

Fabian estimated that the Fed valued munis between 80 and 100 cents on the dollar depending on their ratings. Therefore, the $29 billion posted to the Fed represents up to $36 billion of municipals held on banks' balance sheets. That compares to the data for May, which the Fed first reported on, when it offered $36 billion of loans in return for $45 billion of munis pledged as collateral.

Fabian said the drop in collateral means there are fewer floating-rate bonds held on bank balance sheets. When variable-rate investors put bonds back to the issuer, banks - which provide liquidity for the investors - hold the bonds until they can be remarketed or refunded by the issuer as fixed-rate debt.

Banks have redeemed the bonds by borrowing from the Fed and posting the bonds as collateral. As banks post fewer munis to the Fed, it suggests that they need less cash to redeem investors, according to Fabian.

"We hear regularly that there are far fewer bank bonds than before," he said in an interview. "The sense in the market is that liquidity is improving. There is better demand and better funding."

Tax-exempt money market funds, which invest in variable-rate securities, are usually required to keep bonds of higher credit quality. If the issuer gets downgraded below a certain level or the liquidity provider gets downgraded, mutual funds are required to put the variable-rate bonds back to the bank.

This was almost never an issue before the credit crisis, said Michael Decker, co-director of the Regional Bond Dealers Association. But as liquidity providers were downgraded, the volume of bank bonds spiked.

"The situation in bank bonds has improved steadily since the winter," Decker said, while adding that "there is a larger volume than normal of bank bonds."

Other factors have caused banks to hold munis that the Fed data might not reveal, Decker said. The Fed data does not show the amount of munis held by banks under the bank-qualified limit. Banks have a greater incentive to hold bank-qualified bonds after the stimulus law was enacted in February. Also, he said, banks have been buying back auction-rate securities from investors holding the bonds.

However, the variable-rate market shows little sign of returning to its pre-crisis size. In August, issuers sold 70% less variable-rate demand obligations compared with a year ago, according to data from Thomson Reuters. The number of LOCs provided was also down 70%.

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