Municipal bond owners, have you checked your bonds that are backed by letters of credit from major commercial banks? You may be in for a surprise. Most of those banks have had their credit ratings downgraded. This affects not only the creditworthiness of the bonds, but their marketability as well.
Letters of credit (LOCs) came into use in the early 1980s when interest rates were high and underwriters needed a gimmick to sell new issues. Buyers were afraid that recessions and high interest rates could lead to defaults by certain types of issuers. A "credit enhancement" was needed.
Underwriters came up with LOCs, whereby a bank agreed to supply a line of credit to pay the principal and interest on a bond issue if the issuer was unable to do so. This provided several things: a nice, safe fee for the bank, since few LOCs have ever been used; a way for banks to earn income by not increasing their asset base, because LOCs were carried off the balance sheet, so they did not require reserves against them; bond issuers were able to improve the credit quality of their issues, because their credit ratings were based on the higher ratings of the banks; with a good rating, the marketability of the issue was improved; and the higher rating allowed issuers to sell their bonds at a lower cost.
Goldman Sachs & Co. notes that since 1983, commercial banks have provided LOCs for about $144 billion in municipal bond issues. Many of those issues have been retired or matured. In 1983, 72 percent of the LOCs were provided by U.S. banks. By 1990, U.S. banks were providing about 10 percent of the LOCs (now about $15 billion a year), European banks a little over 10 percent and Japanese banks around 72 percent.
The financial problems that have befallen the U.S. banks have taken a toll on their credit ratings. In 1990, Moody's Investors Service Inc. downgraded 41 banks that were major providers of LOCs, and this affected some $45 billion of municipal debt backed by LOCs. Of the 41 banks, 24 were domestic, affecting $6.68 billion of debt; two were European, affecting $620 million of debt; and 13 were Japanese, affecting $37 billion of debt (82 percent).
The credit deterioration of the banks is manifested in the marketplace, because fewer LOC issues are trading, and they trade at a 75-basis-point discount to the high-grade municipal market. Depending on your tolerance for risk, you could use the current rally to sell your LOC-backed issues, or you could use this as an opportunity to buy the banks you think will survive.
The Treasury will auction two-year notes on Wednesday in $5,000 minimums and five-year notes on Thursday in $1,000 minimums. They should return 6.83 percent and 7.45 percent, respectively.