City budgets' pain could be banks' gain.

The prolonged economic malaise has taken a toll on a growing number of municipalities across the country, with some even struggling to pay their employees. A number of cities are facing challenges tapping into the bond market, which has been a classic funding source. So more governments are turning to banks for an alternative financing vehicle: tax anticipation notes.

Amalgamated Bank issued its first tax anticipation note last month, making a $6.3 million loan to Scranton, Pa., that will let the city make payroll and cover past-due bills.

The safety offered by a municipality's ability to collect taxes is appealing as collateral, and bank will look for more chances to issue such notes, says Edward Grebow, Amalgamated's president and chief executive.

"If a tax anticipation note is properly structured, it's very secure," Grebow says. "It's short-term and it serves an important public purpose."

Other banks should take a look at tax anticipation notes, says Bill Brandt, the president and chief executive of Development Specialists, a restructuring consulting firm in Chicago. He says the notes will not be a cure-all for the industry's long-running problem of lackluster loan demand, but they can still be a good source of revenue.

"If you're building your bank's business plan on this market, you're sadly mistaken," Brandt says. "But some bankers are going to decide that this is a growth segment and say, 'Let's get into this.' "

An increased demand from cities for short-term loans comes as advocacy groups like the Move Your Money Project and the Occupy movement have pressured municipal governments to conduct more business with locally headquartered community banks.

Montgomery County, Md., earlier this year withdrew about $10 million in deposits from its primary bank, PNC Financial Services Group (PNC) in Pittsburgh, and redistributed the funds at a variety of local banks and thrifts.

Tax anticipation notes are a familiar product for many community banks, says John Depman, the national leader of regional and community banking at KPMG.

Banks have long been involved in the business of accepting municipal deposits, where a city parks its cash at a bank for half the year. The rest of the year, while a city waits on yearly tax revenue to be collected, the government takes out a tax anticipation note to meet cash-flow needs, Depman says.

"Banks have done this kind of lending and deposit-collecting for a number of years," Depman says. The current opportunity is to give an assist to cities that face "strong headwinds" from declining tax receipts, he says.

"For those banks that have been in the business of taking municipal deposits, there is probably more demand for tax anticipation notes," Depman says. "For those banks that aren't in that business now, there's an opportunity to get in."

Bigger banks are also involved in the business of making tax anticipation loans.

KeyCorp (KEY) in Cleveland was expected to serve as the lender for $16 million of tax anticipation notes with the Pontiac School District in Michigan, after Fifth Third Bancorp (FITB) in Cincinnati dropped out, according to the The Bond Buyer.

Amalgamated is booking the Scranton tax anticipation note as a loan, says Stephanie Parker, the New York bank's chief credit risk officer. The note bears a 5% rate and matures on Dec. 15. Scranton also paid Amalgamated a 3% fee on the note.

Other cities in financial distress will likely need to borrow more than Scranton's amount, and larger loans would be more attractive to lenders, Brandt says. In many instances, community banks are the most likely option for distressed local governments because of their close knowledge of the workings of the community, Brandt says.

But that intimate connection cuts both ways. "A banker has to pause at the thought of having to foreclose on city hall," Brandt adds. "It needs to be local entities that are doing these loans, not only out of economic factors, but also a civic commitment."

Amalgamated, which is owned by unions, was referred to Scranton by union leaders in the city government's employee base.

Scranton was forced to seek alternative lending when the city parking authority defaulted on a loan. The tax anticipation loan to Scranton made financial sense, Parker says.

"At the end of the day, we have shareholders and we make economic decisions," she says. "We can't make loans that aren't profitable, or we won't be in business very long."

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