Regional President Speech

Remarks of Frank E. Morris, President D Federal Rese B ston f before t .e 1rst Public Finance Con erence Securities Industry Association Broadmoor Hotel, Colorado Springs, Col~ September 15, 1972 There are two clouds hanging over the future of state and local finance: one is political in nature, the other economic. The political issue is, of course, the issue of tax reform. It impinges on municipal finance because the traditional financial instrument of state and local governments is itself a major item on the agenda of tax reformers. Tax reform, fortunately, is not the province of the Federal Reserve. I mention it here only because it has an important bearing on the economic cloud, which is one in which the Federal Reserve has a clear interest. Even if the political cloud over state and local finance were to dissipate, which seems unlikely in the climate of the ?O's, the economic cloud will still remain -- the probability that the supply of bonds coming into the municipal bond market in the decade ahead will grow much faster than the ability of the present tax-exempt market to absorb in any rea sonably efficient manner. The history of the municipal bond market is that it has tended to perform relatively well whenever the economy had - 2- a substantial amount of slack and commercial banks had both the resources and the inclination to absorb 70% to 80% or more of the new offerings. When these conditions did not prevail, it has tended to perform relatively poorly. In tighter money markets, interest rates on municipal bonds had to rise high enough to induce individuals to absorb that part of the market which the commercial banks were forced to vacate in order to meet the borrowing needs of their business customers, large and small. The decade of the 1960's was the golden age for the tax-exempt bond market, primarily because of the greatly increased participation of commercial banks as investors in the market. During the decade of the S0's, commercial banks absorbed less than 21% of the net new issues of municipal bonds; during the 60's they absorbed almost 70% of the new issue volume. As you all know, however, their support of the municipal market had considerable cyclical volatility. In the tight money years of 1966 and 1969, commercial bank participation in the market declined to only 33% and 5% of the new issue volume, respectively. At the end of 1960 commercial banks owned about 25% of the total of municipal bonds outstanding; by the end of 1970 they owned almost 50% of the total outstanding. At the end of 1960 municipal bonds constituted less than 9% of commercial bank portfolios; by the end of 1970 this percentage had risen to more than 15%. Commercial banks found room in their portfolios for this great increase in municipal bonds by reducing the percentage - 2- a substantial amount of slack and commercial banks had both the resources and the inclination to absorb 70% to 80% or more of the new offerings. When these conditions did not prevail, it has tended to perform relatively poorly. In tighter money markets, interest rates on municipal bonds had to rise high enough to induce individuals to absorb that part of the market which the commercial banks were forced to vacate in order to meet the borrowing needs of their business customers, large and small. The decade of the 1960's was the golden age for the tax-exempt bond market, primarily because of the greatly increased participation of commercial banks as investors in the market, During the decade of the SO's, commercial banks absorbed less than 21% of the net new issues of municipal bonds; during the 60's they absorbed almost 70% of the new issue volume. As you all know, however, their support of the municipal market had considerable cyclical volatility. In the tight money years of 1966 and 1969, comme_rcial bank participation in the market declined to only 33% and 5% of the new issue volume, respectively. At the end of 1960 commercial banks owned about 25% of the total of municipal bonds outstanding; by the end of 1970 they owned almost 50% of the total outstanding. At the end of 1960 municipal bonds constituted less than 9% of commercial bank portfolios; by the end of 1970 this percentage had risen to more than 15%. Commercial banks found room in their portfolios for this great increase in municipal bonds by reducing the percentage -3- of their assets held in United States Government obligations from almost 31% at the end of 1960 to a little over 13% by the end of 1970. I believe that there was a one-shot quality in the level of support of the municipal bond market by commercial banks in the 60's. In my judgment, the commercial banks will not be in a position to support the municipal market on a similar scale in the ?O's. This is the principal reason why I think we must be planning now for the establishment of an alternative, taxable market for municipal bonds. One element in the problem is the sheer volume of projected state and local issues. Net new issues of municipal bonds rose from $5.2 billion in 1960 to $11.8 billion in 1970 and a whopping $20.2 billion last year. We are projecting a "normal level" of net new issues of $31.1 billion in 1980. What would be required of the commercial banks, given this projected volume, if they were to lend the same degree of support to the municipal bond market in the 70's that they did during the decade of the 60's? We estimate that if the banks were to absorb, on the average, 70% of the net new issue volume through 1980, commercial bank holdings of municipal bonds would have to rise from the end of 1971 level of $82.9 billion to about $225 billion by 1980. This would mean that commercial banks would own more than 61% of the total outstanding volume of the state and local issues and that municipal bonds would constitute -4- 21% of commercial bank portfolios. This, in my judgment, is not likely to happen for the following reasons: 1. Many banks, large and small, are already finding that there are both limits to the amount of tax-exempt income that they can effectively utilize and limits to the amounts that they can invest in tax-exempt securities if they are to be prepared to meet the needs of their commercial and industrial customers. 2. The bank holding company vehicle is providing commercial banks with new ways of employing their funds which will compete powerfully in profitability with investments in municipal bonds and some of these alternative investment oppor tunities, such as leasing companies, generate large depreciation throw-offs which may substantially reduce the need for tax exempt income. 3. The larger banks in the country which have mature foreign branches are now generating large foreign tax credits which also reduce the need for tax-exempt income. This is one reason why municipal bonds are currently a declining proportion of the portfolios of the weekly reporting member banks of the Federal Reserve System. 4. Commercial banks, both large and small, have reduced their portfolios of United States Government bonds close to a practical minimum. Their ability to make further shifts in portfolio composition in favor of municipal bond holdings at the expense of U.S. Government bond holdings is going to be much more limited in the 70's than it was in the 60's. -5- For these reasons I firmly believe that commercial banks will not be able to play in the future the dominant role which they have played 1n the past in supporting the municipal bond market. Questions of tax equity aside, there are simply not going to be enough high-bracket individual investors to support at reasonable interest rates the $31 billion net new issues of tax-exempt municipal bonds in 1980. These are the reasons why I feel that state and local governments must have available to them an alternative, taxable bond market instrument if they are to meet their capital needs in a reasonably adequate manner during the decade ahead. In closing I want to commend the Securities Industry Association for recognizing the need for change well in advance of any crisis condition in state and local finance and for lending your support to the proposal for an alternative market of taxable municipal bonds with a Federal Government interest subsidy. This represents a very hopeful departure from the norm of the past in which the Congress and state legislatures have imposed change on the industry following crises which the industry did not foresee or, at least, publicly recognize. In this instance the industry had the benefit of the forward-looking leadership of my fellow panelist, Frank Smeal. I do not know how Mr. Smeal managed to work the industry away from its traditional posture of a stubborn defense of the status quo, but I would hope that it is a harbinger of things to come. Certainly, I know that Frank Smeal did not make a -6- lot of new friends in the industry in the process; but if it's any consolation to him, I suspect that my former boss, Bill Martin, with his great integrity and public spirit, never had as many friends on the New York Stock Exchange as Richard Whitney. The decade of the 70's seems certain to be one of accelerating change, with the financial sector of the economy changing much more rapidly than most. We in the Federal Reserve will have our hands full adapting monetary policy to this changing financial scene. In this we will have much in common with the leadership of the securities industry. An urbane and articulate defense of the status quo is not likely to be adequate for either of us.

Frank E. Morris (1972, September 14). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19720915_frank_e_morris

@misc{wtfs_regional_speeche_19720915_frank_e_morris,
  author = {Frank E. Morris},
  title = {Regional President Speech},
  year = {1972},
  month = {Sep},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19720915_frank_e_morris},
  note = {Retrieved via When the Fed Speaks corpus}
}