By Paul Peduto

Printable Version

Municipal deposits are an excellent source of low-cost funds for many banks and credit unions. But there may be a hidden cost that makes them less attractive than they appear.

Most municipalities require security on their deposits, either in the form of excess deposit insurance or by accepting investment securities from the depository bank or credit union, usually in the form of government or agency securities.

Banks and credit unions may be giving up earnings if they are keeping a portion of their securities portfolio mainly for the purpose of securing these deposits. Can members better deploy these investment securities into loans that provide a higher yield, allow their securities portfolios to shrink (as is widespread in today’s thin-margin environment), or keep their securities unencumbered for other uses?  We think they can by using Federal Home Loan Bank of Boston letters of credit instead of securities to secure their municipal deposits.

An FHLB Boston letter of credit is a triple-A-rated instrument where FHLB Boston promises to pay a third-party beneficiary (in this case, the municipality) in the event of default by the maker (in this case, the member). Although FHLB Boston requires collateral for the letter of credit, the collateral can be derived from the same menu of assets eligible to secure FHLB Boston advances, including one- to four-family residential mortgage loans and higher-yielding commercial real estate loans. In many cases, members already will have excess collateral pledged at FHLB Boston that can be used for letters of credit.

The cost of an FHLB Boston letter of credit is very reasonable at nine basis points per year for a letter of credit of $10 million or more; 12.5 basis points for $1 million to $10 million; and 25 basis points for those under $1 million. The additional yield pickup for moving from securities to loans should easily offset the cost of the letter of credit.

FHLB Boston letters of credit are acceptable collateral in many municipalities in New England and New York (we understand that Connecticut and Rhode Island laws and regulations do not allow FHLB Boston letters of credit to be used to secure municipal deposits). Because their face amount remains constant, there is no need to update the amount pledged on a monthly basis, saving both you and the municipality valuable time.

Many members have taken advantage of this product, with outstanding letters of credit at FHLB Boston of $2.0 billion on March 31, 2007, compared with $0.1 billion one year earlier.

Please contact your relationship manager or visit FHLB Boston's letters of credit web page for further information on this valuable financial instrument.

Paul M. Peduto is first vice president/sales and business development at the Federal Home Loan Bank of Boston.