MIAMI — Municipalities are borrowing more money directly from banks that are competing to offer favorable rates and terms.

The direct loans from banks are here to stay, though some risks about their use are still unknown, experts said at the Fourth National Municipal Bond Summit here Thursday.

While the exact amount of direct bank lending is unclear, estimates range from $10 billion of the transactions in 2009 up to $40 billion last year, according to Alex Wallace, managing director and head of public finance for U.S. Bancorp.

One of the main drivers for using a direct loan has been as a substitution for a credit facility when banks are downgraded. Very little new-money borrowing has been done through direct loans, Wallace said. He expects fewer credit conversions this year, and for direct-purchase volume to remain flat relative to 2011.

“This is an evolutionary product,” Wallace said. “It’s one that is transforming the marketplace. The industry is still trying to decide how big this market should be and how best it should be regulated.”

Wallace noted that most recent direct purchases have occurred in a low interest-rate environment and few, if any, have gone through renewals.

Direct loans are attractive to municipal issuers for several reasons, said Ronald Rumack, senior vice president and team leader of municipal credit enhancement for Sumitomo Mitsui Banking Corp.

“They are here to stay, they are easily customized, and a cheaper method of financing,” said Rumack, who views letters of credit as direct purchases, though there are some fundamental differences.

He said direct loans cut out the remarketing agent and do not require ratings or CUSIPs.

Rumack and others said they encourage issuers to disclose use of the loans even if they have no long-term debt outstanding.

“We believe transparency is important to investors,” he said.

“From a bondholders perspective, they should be concerned about all aspects and terms that can affect the financial position of an issuer.”

“Certainly, some issues exist for the future of this market, but generally I think you have bank downgrades, issuers have swaps and need access to funding sources,” he said.

Though top investment banks are offering the product, First Southwest Co. managing director Ed Stull said many regional banks have been “very aggressive” on terms and conditions.

Competition between banks has provided attractive terms such as elimination of a reserve fund, locking in good rates, and the ability to pre-pay without penalty, Stull said.

“We are encouraging our issuers to disclose [bank loans] on EMMA and to rating agencies,” he said.

Stull said there has been discussion about direct loan purchases, but the Municipal Securities Rulemaking Board does not consider them municipal securities.

“Clearly, there are limitations to this product, like any other product,” Wallace said. “We think it works best in the context of the overall role of a financing strategy. It is not one size fits all.”

“This product is here to stay,” he added. “I think it will remain a viable alternative product for banks who still have depressed ratings.”

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