A change in the methodology the Federal Reserve uses to measure who owns municipal bonds has masked the growth in foreign ownership of state and local government debt.

The latest Fed flow of funds report last week showed foreigners owned $52 billion of municipal bonds at the end of the third quarter, reflecting only marginal growth this year.

This is improbable because 36% of the state and local government debt issued in 2010 has been taxable, and dealers for more than a year have been reporting that foreigners have an appetite for taxable municipal debt.

In fact, until now the Fed itself has been reporting that foreigners have an appetite for taxable municipal debt.

The "rest of the world" for several quarters has been the fastest-growing holder of municipal bonds, according to the Fed's own flow of funds reports.

The Fed's second-quarter report showed foreigners owned $83 billion of municipal bonds at mid-year, representing growth of 37% in 2010 and 66% since the first quarter of 2009 — just before Build America Bonds began to be issued.

A spokesperson for the Fed confirmed it adopted new methodology for determining foreign muni ownership. The change resulted in sharp downward revisions of foreign municipal holdings from previous quarters.

The latest report, for example, shows foreigners owned $51.5 billion of municipals at mid-year. In the report that originally came out for the second quarter, the Fed reported foreigners owned $83 billion of municipals at that time.

Data going back to the second quarter of 2009 was revised downward.

"It doesn't explain what the dealers who sell these products have been saying," said Richard Ciccarone, director of municipal research at McDonnell Investment Management. "There's definitely a discrepancy about the perceived impact of these bonds being sold overseas, and what these numbers suggest."

The bonds subtracted from the foreigners category appear to have been chucked in the catchall "households" category, which includes retail investors, unions, churches, schools, and anything else that doesn't make it into another category.

The Fed began to restructure its classifications in the "rest of the world" category after the second quarter. That quarter's flow of funds report saw major revisions in most types of foreigners' assets, with municipal securities one of the categories not revised. That revision occurred in the latest quarter.

Ciccarone said these reports help color debates on tax policy and regulations.

The stock of municipal bonds outstanding grew slightly during the quarter to $2.86 trillion, meaning the industry is now bigger than it has ever been.

Among the biggest buyers were commercial banks, who bolstered their holdings by 4%, to $229.1 billion.

Banks finally responded to stimulus provisions designed to coax more bank buying of munis. These included allowing certain banks to deduct the carrying costs of tax-exempt bonds from their taxes, as well as an increase in the ceiling for how much debt an issuer can sell in a year and remain bank-qualified, to $30 million from $10 million.

A period of greater profitability is also helping. Banks reported $10.5 billion of operating income during the third quarter and $18.5 billion in the second quarter, according to the Federal Deposit Insurance Corp., compared with $3 billion in operating income in the third quarter last year and a $24.4 million loss in the second quarter last year.

Banks now own 8% of outstanding municipal bonds, the highest share since the fourth quarter of 2008.

Mutual funds were also big buyers of munis during the third quarter, prodded by inflows of new money from investors. Investors entrusted $11.2 billion to municipal bond mutual funds during the third quarter, according to the Investment Company Institute.

Mutual funds at the end of the third quarter owned $532.8 billion of municipal bonds, marking growth of 3.6%.

At 18.6%, mutual funds' share of the outstanding municipal market at the end of the third quarter was the highest ever, though outflows since then will probably pull that share back down.

Tax-free money market funds continued to lose their share of outstanding state and local government debt as both investors and issuers migrate away from cash instruments.

According to the ICI, tax-free money funds coughed up about $16.9 billion during the third quarter as investors sought higher-yielding alternatives.

Supply has also been waning for money funds because the bank liquidity that typically must accompany money fund-eligible paper has become scarce and more expensive. Municipal governments through the first 11 months of the year have sold just $17.14 billion of short-put variable-rate demand obligations, according to Thomson Reuters, a decline of 42.5% from last year.

VRDOs are the primary item tax-free money funds buy.

The tax-free money fund industry held $331.6 billion at the end of the third quarter, the lowest total since the third quarter of 2005. Its 11.6% share of the muni market is the lowest since 1996.

Property-casualty insurance companies beefed up their holdings by 0.7% to $371.1 billion. Property-casualty insurance companies own 13% of outstanding municipals.