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A new plan to help the ailing municipal bond market may help public finance attorneys solve a problem vexing local governments since the subprime collapse. Local public agencies, including cities, counties and even some nonprofits, are paying high-penalty interest rates to skittish investors unable to dump the increasingly undesirable bonds. To protect the agencies from the penalties, lawyers at Orrick, Herrington & Sutcliffe have devised a new method of creating one-year notes secured by the bonds to better entice investors, and will start next month with at least $1 billion worth of the one-year notes. “Each $1 billion of notes issued . . . will save local government taxpayers and ratepayers as much as $50 million or more,” said William Doyle, a partner in Orrick’s San Francisco office who created the financing structure. Orrick, which has long represented many bond issuers, is note counsel to a coalition of public agencies – the California Statewide Communities Development Authority. The problem, Doyle said, is one of investor confidence, so the trick is to give investors less reason to sell the bonds – or to inspire a new group of investors to pick up the slack. The subprime collapse hurt the credit ratings of the municipal bond insurers, which left money-market mutual funds legally barred from investing in the bonds. Doyle said the mutual funds are itching to pick up short-term, tax-exempt notes for their pools of individual investors, but can’t. The notes benefit from the strength of numbers – they will be backed by the pooled credit ratings of all the issuers, which is higher than that of any individual issuer. If investors regain faith in municipal bonds, they will return and restore some liquidity to the market. Doyle said the one-year notes should hit the market the week of April 21. Governments issue bonds backed by insurers as a cheap means of raising money, but the subprime crisis made the cheap money expensive, because investors began exercising options to unload the bonds, which brought penalties of 8 to 15 percent to the municipalities, when the bonds could not be sold. The problem, Doyle said, isn’t the bonds, which remain safe. Their insurers, however, also backed the collateralized debt obligations largely responsible for the subprime collapse, which led credit agencies to slash many insurers’ ratings. That skewered investor confidence. “You just have a lot of people who are rationally or irrationally moving away from the municipal market,” said Clifford Gerber, a partner in the San Francisco office of Sidley Austin who oversees the tax practice with respect to financings by the West Coast public finance group. At issue are auction-rate securities and variable rate demand bonds. Investor flight from auction-rate securities is especially problematic. “They only have a right to submit their bond to the auction,” Gerber said. Fleeing investors auction their bonds to an increasingly shrinking pool of their peers, and those auctions are increasingly failing. The investors are stuck with the bonds, which triggers a provision forcing municipalities to pay higher interest rates. “The failed auctions have increased the cost dramatically for a number of municipalities that have issued auction-rate securities,” said Bob Fields, a senior vice president in the Newport Beach office of PIMCO, a money management company. A similar penalty problem comes into play with the variable rate demand bonds, which are backed by letters of credit from banks. Investors looking to shed VRDBs sell the bonds back to banks, which again triggers higher interest rates. Many money-market mutual funds were forced to sell billions of VRDBs as insurer credit ratings fell below the minimum legally allowed limit for the funds. And while banks benefit from the high penalty rates, they are not exactly ecstatic about having to tie up previously available capital in an already tight market. On Thursday, Wells Fargo brought its top-notch AAA rating to the effort by agreeing to be the lead letter-of-credit bank behind the new notes, Doyle said. While the solution is only temporary – the notes have a lifespan of just one year – it should buy cities, counties and other public agencies time until investors make their way back to the market or until the existing bonds can be converted to safer vehicles. And the initial $1 billion of notes may be just the beginning. The coalition wants to offer the notes as long as there is a need. “The hope and the plan,” Doyle said, “is to do a series every week to two weeks, based on demand.”

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