The return of bank profitability, coupled with some of the provisions of the federal stimulus, coaxed banks to buy state and local government debt in the first half.

Banks beefed up their municipal holdings by 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, a municipal strategist at Citigroup Inc., referring to bank profits.

Banks lost $20.6 billion before taxes in 2008.

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

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. This legislation eliminated the tax advantage for bank ownership of municipal debt by taxing the bonds' carrying costs.

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 response to the credit crisis, the federal government wrote several clauses into the American Recovery and Reinvestment Act, or ARRA, of 2009 designed to stimulate banks' purchases of municipal bonds.

One was to increase the threshold for bank-qualified debt, to a $30 million cap. This expanded the amount of tax-exempt debt available for banks to buy.

"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 that have been 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 in the previous four years combined.

The other stimulus-law provision that has been important for increasing banks' muni ownership was one that lets financial institutions deduct 80% of the cost of carrying tax-exempt bonds, so 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 proposed extensions of the Build America Bonds program would also extend the more permissive threshold for bank-qualified issuance.

Banks' ownership of municipal bonds has grown every year since 1995.

Ciccarone pointed out that municipal bonds probably are 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, for 2.9% growth.

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

Wells Fargo & Co. vaulted six spots, to No. 2, on the list, thanks to the incorporation of Wachovia Corp.'s holdings onto its books.

Bank of America Corp. 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.

Banks' regulatory reports do not break down their municipal holdings by whether they are taxable or tax-exempt. Citi's 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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