Many community banks find that the benefits of lending to municipalities for essential services outweigh the risks.
By Beth Mattson-Teig
Drive by a fire station, school or city hall these days and odds are that the money used to pay for essentials—ranging from school buses and fire trucks to computers and computer systems—was financed by a community bank.
Municipal financing for equipment and construction projects is an attractive and growing niche for many community banks. Morrisville, Vt.-based Union Bank conducts hundreds of municipal financing transactions each year. “We view this as an important part of our overall product mix, and we are looking to grow this area of our business in tandem with growing the rest of the bank,” says Union Bank president David Silverman.
The $700 million-asset bank has a $550 million loan portfolio, about 10 percent of which consists of municipal loans and bonds. “Any kind of financing that a municipality or school district might undertake is something that we would take a look at,” Silverman says. In addition to purchasing municipal bonds, community banks offer a wide range of loan products, such as tax, bond and grant anticipation loans, along with financing for current expense needs, capital improvement projects and equipment purchases.
Union Bank is particularly active on tax anticipation notes or revenue anticipation notes, where it provides financing for communities in anticipation of their receipt of proceeds, such as from property taxes. “We bridge the gap and provide a loan from the time they need to pay expenses from the time they actually receive the taxes,” Silverman says.
How cities access financing varies on a case-by-case basis. The city of Delano, Minn., for example, is a Minneapolis suburb of about 6,000 people that generally uses existing revenues and cash reserves to finance its smaller projects. The city seeks outside financing only once or twice each year for major capital purchases or construction projects, notes city administrator Phil Kern.
The vast majority of Delano’s financing efforts involves issuing tax-exempt bonds for 10- to 20-year terms, Kern says. For example, the city made a $5 million bond issuance last year for a street and utility construction project. Those bonds are put forth for banks and other investment groups to publicly bid on, and cities accept the bid with the most favorable terms.
“Community and local banks are just as competitive as others, although sometimes the size and scope of what we are looking for exceeds the interest or desire of a local bank to bid on it,” Kern says.
Several factors are fueling banks’ appetite for municipal lending. The big driver for many is to serve the local community—and to retain those municipal customers long after the original loan is granted.
“When it comes to municipal lending, it boils down to a lot of relationship management,” says Rhonda L. Bennett, vice president of commercial and municipal services at Union Bank. Those transactions open the door to other business on the deposit side for those municipalities, as well as more automated banking services, such as remote deposit capture.
Union Bank does most of its municipal business with towns, villages and school districts within a 30-minute drive from any of its 20 branch locations across Vermont and New Hampshire. “Municipalities represent a very strong deposit opportunity, and we strive to be the bank of account for as many of our local municipalities as we can,” Silverman says.
Other banks have a more targeted focus on municipal lending as a specialty niche. For example, the $1.7 billion-asset KS StateBank in Manhattan, Kan., merged with Baystone Government Finance 10 years ago. The division originates and funds about $200 million in municipal obligations annually for equipment purchases and projects across the US.
Municipal financing can be profitable. However, that profitability depends on pricing. “This is a competitive business, and the muni lease companies will aggressively go after deals that fit their profile,” says Evan Howe, director of Baystone Government Finance. Howe adds that community banks also typically bid low rates on transactions where they want to win that local business.
Profitability also depends on creating efficiencies to manage that business. “About half the states have specific laws that affect municipal leasing,” Howe says. “You have to know the laws and manage that process.” Banks do incur legal costs, and processors need to be trained to manage the documentation. “You must manage the documentation process efficiently if you want to keep your costs down and stay competitive in the marketplace,” he says. “In other words, you can’t just decide to start doing municipal leasing and expect to have a high-quality, large, profitable portfolio jump into your bank.”
Managing credit risk
Howe says municipal leasing risks are not much different from other commercial lending risks. One way to mitigate those risks is to balance a portfolio by ensuring differentiation among the issuers and types of equipment or projects being financed. Some lenders are also more cautious in financing controversial projects. For example, Baystone tries to avoid financing politically unpopular deals, such as those the community voted against on a bond issue.
“There is risk in municipal leasing,” Howe says. “However, if you go after the essential-use equipment, finance it within its useful life, manage the portfolio professionally and work with good vendors, you will be paid back over 99 percent of the time.
“If you stray away from this type of underwriting and chase the more exotic deals that have more rate in them, then you will most likely still have a good asset, but they may not perform quite as well.”
Generally, municipal loans and bonds are backed by the full faith and credit of the municipality, which also has taxing authority to generate revenue. “These are very low-risk loans in general, and we are able to accept a lower interest-rate yield as a result,” Silverman says.
Some risk still exists. In several high-profile cases, cities have struggled with large budget deficits, weak credit and an inability to pay outstanding debt. When a municipality is unable to pay back its debt, it may file for Chapter 9 bankruptcy. Several cities have filed for bankruptcy protection in the past decade, including Detroit, Stockton, Calif., and Jefferson County, Ala., among others. The most recent case making headlines is that of Hartford, Conn. The city has seen its credit rating drop to junk bond status as it continues to struggle under a heavy debt burden and a potential bankruptcy filing. However, municipal defaults remain rare.
The bigger risks in municipal lending generally relate to documentation or legal risk. “You need to make sure the community actually has the authority to do the borrowing, and that typically means bringing in municipal counsel and making sure that the municipality has followed the procedures embedded in statute,” Silverman explains. For example, a city statute might have to disclose borrowing in an annual meeting, or the governing body of that city has granted the necessary approvals for that financing.
In addition to underwriting and diligence, banks use existing relationships to help manage risk. “We know the people that we are lending money to,” Silverman says. “We believe that mitigates the risk a great deal.”
Beth Mattson-Teig is a freelance business writer in Minnesota.