February 16, 2011


Banks are setting aside billions of dollars to do something that until now was rarely heard of: making big loans to cities, states, schools and other public borrowers that otherwise might have turned to the bond market.

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When Riverside, Calif., was ironing out a bond offering recently to expand its performing-arts center, several banks pitched a radical idea: Why not take out a loan instead? The city scrapped the bond plan and borrowed $25 million from City National Bank in Los Angeles.

“This was a method we’d never even heard of before,” says Scott Catlett, the city’s assistant finance director. He says Riverside now intends to seek a bank loan for a conference center that it had planned to build with bonds.

It could find a robust reception for its business. Banks are aggressively courting municipal borrowers with conventional loans for capital projects.

This effort, known as direct lending, is partly directed at borrowers like Riverside that need money to build and have relatively good credit ratings.

In other cases, the loans are aimed at helping public borrowers, for a price, out of a squeeze that banks helped create. During the financial crisis a few years ago, many public borrowers floated bonds backed by bank guarantees called letters of credit.

This year, about $53 billion of those letters of credit are expiring, according to Thomson Reuters. Municipal borrowers struggling to refinance this debt face tough new terms and interest rates at banks.

J.P. Morgan Chase & Co. is devoting billions of dollars to direct loans this year to both refinance deals and for new projects, according to a bank official. Last year, the bank made a few hundred million dollars of direct loans to municipalities. Now, the bank would consider making a single loan for hundreds of millions of dollars, the official said. It also is dispatching teams to explain the concept to wary public borrowers.

Citibank also is courting municipal borrowers with direct loans, according to several bond issuers. A spokesman for the Citigroup Inc. unit declined to comment.

“This used to be unheard of,” says Eric Friedland, managing director of public finance at Fitch Ratings, noting that in the past, banks would occasionally loan a municipality less than $1 million to finance projects too small for a bond offering. For bigger loans, they would form a syndicate with other lenders.

It remains to be seen what land mines may be lurking for lenders and borrowers. Some municipalities are going through significant struggles, raising questions about whether they will prove good credits. And direct loans are less liquid, meaning banks can’t sell them as easily as bonds.

For borrowers, many of these loans must be paid back more rapidly than a bond. So the loans could prove something of a time bomb for borrowers.

Municipalities that have taken out direct loans say interest rates are typically lower than they would pay in the bond market, and they don’t have to pay underwriters and lawyers to prepare a public offering. They also can avoid the documents and administration involved in the public disclosure required for bond offerings.

Elgin Academy, a preparatory school in Illinois, turned to direct lending to replace an $11 million bond for improvements on campus. The bond had been supported by a letter of credit, according to a person familiar with the matter. During the financial crisis, bondholders sold, forcing the bank to buy back the bonds at high interest rates, which got passed along to the school. It recently borrowed $10 million from a community bank to get out of the deal.

For banks, this is a potentially lucrative business at a time when they are sitting on cash that isn’t earning huge interest and are reluctant to make loans for mortgages and other areas they see as risky.

The loans help banks comply with new international rules that are requiring banks to put aside more capital to buffer against losses, bankers say.

They also are helping banks dig out of their own deals that backfired and restoring some strained relationships with clients that can provide future business.

In the event of a bankruptcy, analysts say, it is unlikely that a bank extending a direct loan would be given priority over bondholders.

It is more likely that the bank and bondholders would be on equal footing in laying claims to recover their money, though it would depend on what each lender negotiated.

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