State Street, U.S. Bancorp, Citigroup and other banks have increased their holdings of municipal bonds to a 25-year high. Meanwhile, state budget deficits have ballooned to $140 billion, a situation that could lead to trouble for the banks. "There is a huge untold problem here," said Walter J. Mix III, formerly a commissioner of the California Department of Financial Institutions. "The economics lead to the conclusion that there will be downward pressure on these bonds."

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