26 JANUARY / FEBRUARY 2022 Community banks have long served as financial service leaders for their local communities. The need for new and improved infrastructure in the United States continues to rise, resulting in a growing need to finance these projects. There are multiple paths for municipalities to access capital or refinance existing financial obligations, and they are looking to their community banks for assistance. In general, municipalities can enter into a financing agreement by using one or more of the following: % Issuing municipal bonds through a public sale, either as a competitive or negotiated underwriting. % Accessing state or federal aid, such as grants. % Utilizing a state-revolving fund or conduit issuer. % Obtaining bids from financial institutions for a direct loan, a.k.a. a private placement. Over the past 10 years, there has been a significant rise in the issuance of private placements. On the surface, it makes sense for a municipality to consider it the path of least resistance. It’s true that, all things equal, obtaining financing through a private placement involves fewer parties in the transaction and lower fees. There is a growing trend, however, of unintended consequences for both issuers and community banks for private placement transactions that needs to be considered. Private placements can be tricky for community banks. On one hand, community bankers want to support their local communities. On the other hand, bidding on them is challenging. There are risks for Communities in Need Seek assistance from community banks DIRECTORS / SENIOR MANAGEMENT community banks investing in private placements that need to be factored in that include, but are not limited to: % Illiquidity profile. There is not an active secondary market. % Credit profile. They are typically non-rated and non-insured. % Lack of call protection. Most come with any-time call options. % Lending limit constraints. The size of private placements is steadily growing, limiting a bank’s ability to purchase the entire deal. % No continuing disclosure requirements. Creates difficulty for post-purchase credit monitoring. Community bankers are experts in pricing loans, but they don’t commonly price securities in the bond market. Loans have far greater credit risk than the public finance sector, so it wouldn’t be appropriate to use a loan pricing model when bidding on a private placement. According to bank call report data through the second quarter of 2021, the median yield on loans for banks with $500 million or less in assets was 5.26%. Offer anywhere close to that when bidding on a private placement, and you might get run out of town! The questions are, how much lower should the yield be compared to your average loan portfolio, and how much higher should it be compared to a municipal bond of a similar structure? In an efficient market, yields on a private placement should be higher than those seen in municipal bonds of a similar structure. The illiquidity profile, credit Scott E. Fletcher Director of Public Finance The Baker Group SFletcher@GoBaker.com The Baker Group is a Preferred Service Provider of the Indiana Bankers Association and an IBA Diamond Associate Member.
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