The return of bank profitability coupled with some of the provisions of the federal stimulus coaxed banks into buying state and local government debt in the first half of the year.

The 500 Largest Municipal Portfolios at U.S. Banks

Banks beefed up their municipal holdings 2.7% in the first six months of 2010, according to Highline Data. The industry owns $162.2 billion of municipals, based on cost, compared with $158 billion at the end of the year.

A primary impetus was profit.

According to the Federal Deposit Insurance Corp., banks reported $57.85 billion in pretax income in the first half, compared with $1.64 billion in the second half of 2009 and $10.09 billion in the first half of 2009.

Banks typically buy municipal bonds to shelter profits from taxes.

“After a very messy ’07-’08, things looked a little better in ’09 and a lot better in ’10,” said George Friedlander, municipal strategist at Citigroup, referring to bank profits.

Banks lost $20.6 billion before taxes in 2008.

According to the Federal Reserve, banks own 7.8% of outstanding municipal bonds.

Until the 1980s, banks were the biggest buyers of municipal bonds — more than retail investors. Through much of the early 1970s, commercial banks held more than 15% of their assets in municipal securities.

The Tax Reform Act of 1986 changed that. The legislation eliminated the tax advantage for bank ownership of municipal debt by taxing the carrying costs of the bonds.

Today, commercial banks hold about 2.2% of their assets in municipal securities.

The 1986 act carved out a niche for banks by designating bonds issued by governments that float $10 million or less of tax-exempt debt a year as “bank-qualified” — meaning the carrying cost is mostly tax-deductible for banks.

In the wake of the credit crisis, the federal government wrote several clauses into the American Recovery and Reinvestment Act of 2009 designed to stimulate banks’ purchases of municipal bonds.

500 Largest Bank Portfolios: Summary Tables

One was to increase the threshold for bank-qualified debt, to a $30 million cap from $10 million. That expanded the amount of tax-exempt debt available for purchase by banks.

“It was helped along by a wider base for bank-qualified bonds,” said Richard Ciccarone, head of municipal research at McDonnell Investment Management. “They had more selections to pick from.”

About 9% of municipal bonds sold this year, and 8% last year, have been bank-qualified, according to Thomson Reuters, compared with 4% in 2007 and 2008.

Issuers have sold $57 billion of ­bank-qualified debt since the beginning of 2009, more than the previous four years ­combined.

The other provision of the stimulus law that has been important for increasing banks’ muni ownership was one that allows financial institutions to deduct 80% of the cost of carrying tax-exempt bonds as long as their tax-exempt holdings do not exceed 2% of their assets.

Both provisions are slated to expire with the sunset of ARRA at the end of this year.

Several of the proposed extensions to the Build America Bonds program would also extend the more permissive threshold for bank-qualified issuance.

Banks’ ownership of municipal bonds has increased every year since 1995.

Ciccarone pointed out that municipal bonds likely represented an attractive option for banks cautious about lending in the aftermath of the financial crisis.

Bank credit outstanding — at about $9 trillion — is still lower than it was in late 2008, according to the Fed, with industrial loans, commercial real estate debt, and even loans to other banks all down sharply.

Citigroup retained the top spot among bank municipal portfolios, with $15.4 billion in holdings based on amortized cost. That represents 2.9% growth in the bank’s portfolio.

Most of Citi’s municipal portfolio is financed through tender-option bonds, matures in more than 10 years, and has an average rating of double-A-minus, according to the bank’s latest quarterly filing with the Securities and Exchange Commission.

Wells Fargo vaulted six spots to ­number two in the list, thanks to the incorporation of Wachovia’s figures into the bank’s books.

Bank of America was a seller during the first half, dumping $2.4 billion of municipals to bring its portfolio to $7.03 ­billion.

JPMorgan Chase & Co. was one of the biggest buyers, adding $1.5 billion to bring its municipal portfolio to $5.06 billion, sixth among banks.

Municipal portfolios listed in banks’ regulatory reports do not break down whether the bonds are taxable or tax-­exempt. Friedlander said he doubts banks are buying much taxable municipal debt, since the bulk of taxable munis are long-term and banks tend not to buy long-term bonds.

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