By Paul Peduto

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Municipal deposits are an excellent source of low-cost funds for many financial institutions. But there may be a hidden cost that makes them less attractive than they appear. Most municipalities require security on such deposits, either in the form of excess deposit insurance or by accepting from the depository financial institution investment securities, usually in the form of government or agency securities.

Financial institutions may be giving up yield on assets if they are keeping a portion of their securities portfolio mainly for the purpose of securing these deposits. Can these investments be better deployed as loans that provide a higher yield? We think they can by using Federal Home Loan Bank of Boston (the Bank) letters of credit instead of securities to secure the municipal deposits.

A Federal Home Loan Bank of Boston letter of credit is an Aaa-rated instrument in which  the Bank promises to pay a third-party beneficiary (in this case, the municipality) in case of default by the maker (in this case, the member). Although the Bank requires collateral for the letter of credit, the collateral can be derived from the same menu of assets eligible to secure Bank advances, including one- to four-family residential loans and higher-yielding commercial real estate loans.

The cost of a Bank letter of credit is very reasonable at nine basis points per year for a letter 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 to loans from securities should easily offset the cost of the letter of credit.

Bank letters of credit are acceptable collateral in most municipalities in New England. 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.

Please contact your relationship manager 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.