H.R. 1 - The American Recovery and Reinvestment Act of 2009 - contains two provisions that may make tax-exempt municipal bonds more attractive investments for financial institutions.

Under the Internal Revenue Code, a taxpayer may not take a deduction for the interest expense on indebtedness incurred to purchase or carry tax-exempt bonds. For taxpayers other than financial institutions, there has been a “safe harbor” with respect to deductions: as long as one’s adjusted basis invested in tax-exempt obligations is less than 2 percent of one’s total assets, the taxpayer is presumed not to have borrowed to purchase or carry the obligations. However, banks have not had the benefit of this provision – ownership of tax-exempt obligations, unless they were so-called bank qualified bonds, triggered deduction disallowance provisions, effectively lowering the yield to the holder of the bonds.

The Act changes this for 2009 and 2010. The 2 percent safe harbor is extended to banks for those two years. While tax-exempt bonds still constitute “financial institution preference items” for purposes of Section 291 of the Code, the disincentive to banks to own municipal bonds has been greatly reduced. Now they will be able to retain 80 percent of the deductions they otherwise would have lost as a result of owning tax-exempt bonds.

The other major revision is to the socalled “bank qualified” bond provisions. The Code previously permitted state and local government issuers to issue up to $10 million of bonds annually that financial institutions could purchase without being subject to any interest deduction disallowance. This amount is increased to $30 million for each of 2009 and 2010.

Certain other rules make it easier for more issuers, including 501(c)(3) entities, to issue bank qualified bonds. The net effect is that the supply of bonds that offer tax-exempt rates without causing a loss in interest deductions will increase.

It remains to be seen whether these changes will benefit issuers by increasing demand and benefit banks by increasing yields. The coming months will tell.