backing debt with a guarantee does not require an immediate outlay of funds, the federal government could have to cover losses if there are defaults

TO BE NOTED: From the NY Times:

"Localities Want U.S. To Support Muni Bonds

By LESLIE WAYNE

State and local governments are asking Washington to give them something that banks are trying to get rid of: federal bailout money.

California is asking that money from the Treasury’s TARP, the Troubled Asset Relief Program, be used to help back more than $13 billion in short-term borrowings. Members of Congress and several municipalities want bailout money to be used to cover more than $1 billion in losses from investments by municipalities in debt issued by Lehman Brothers, the investment bank that went bust.

And Representative Barney Frank, chairman of the House Financial Services Committee, is drafting legislation that would have the Federal Reserve, and potentially the Treasury’s bailout money as well, stand behind floating-rate municipal bonds — a $400 billion market that provides short-term financing to municipalities, but which has been largely frozen in the current credit crisis.

Another measure drafted by Mr. Frank, Democrat of Massachusetts, would create a public finance office within the Treasury Department to reinsure $50 billion in municipal bonds. This proposal comes as downgrades of municipal bond insurance companies have made it more difficult and costly for state and local governments to issue bonds.

All of the proposals are meant to help struggling state and local governments that are facing a cash-flow squeeze. The economic downturn has eaten into their tax bases as local businesses shut, houses are lost to foreclosure and there is a resistance to raising taxes. The risk to the federal government is that it could lose money if things get worse for municipalities and states. ( NB DON ) Although backing debt with a guarantee( NB DON ) does not require an immediate outlay of funds, the federal government could have to cover losses if there are defaults — which could be substantial if the economy weakens or states and municipalities cannot bring their budget deficits under control. Nonetheless, these overtures by state and local officials reflect a sense — perhaps just a hope — that municipalities suffering from a downturn in revenues and creditworthiness may find some relief in Washington beyond the stimulus money the federal government already is spending.

When the relief program was first conceived of last year, pleas by municipalities for a slice of the money went unheeded by Treasury officials who had earmarked the funds solely for troubled banks and financial institutions. But, in recent days, new conversations have taken place involving Federal Reserve and Treasury officials and state and local representatives that have given rise to cautious optimism.

“The municipal sector has been asking for federal assistance since TARP was just a glimmer in Hank Paulson’s eye,” said Matt Fabian, managing director at Municipal Market Advisors, an independent research firm. “But no one was pursuing it for months. Now, there has been a re-engagement in Washington about using the TARP money.”

Andrew Williams, a Treasury spokesman said, “We’ve had conversations with people from California and with people from around the country about the challenges facing the municipal market. And we continue to study the issue closely.”

In a speech last week at the National Press Club, Treasury Secretary Timothy F. Geithner said that the Treasury is “looking at ways to make sure these markets are working so that states and munis can meet their needs.”

But, according to a Bloomberg News account of the speech, Mr. Geithner cautioned: “I wouldn’t use the word bailout.”

With bailout fatigue setting in, it is unclear how successful the municipalities will be. At a Congressional hearing last Thursday called by Mr. Frank, federal officials remained cool to the idea of tapping into the relief fund, while still expressing concern over a credit squeeze facing many municipal borrowers.

David W. Wilcox, a deputy director at the Federal Reserve, said at the hearing that the Fed is “quite concerned” over any proposal that would extend federal guarantees to municipal debt. But, he allowed that if Congress does take that course, it should “tailor any government intervention in the municipal bond market relatively narrowly” and provide for a quick government exit when market conditions improve.

On the same day, Mr. Geithner told a House Appropriations subcommittee that the relief money cannot be used to resolve local government budget crises, since that money has been reserved for financial companies.

He said, however, that the Treasury would work with Congress to help states like California, which have been struggling to arrange backing for municipal bonds and short-term debt. Mr. Geithner did not provide any specifics.

Clearly, market conditions are not favorable in several corners of the municipal bond market, which consists of more than 50,000 public entities that have issued about $2.7 trillion in debt.

In April, Moody’s Investors Service issued its first-ever blanket report on municipalities and assigned a negative outlook on the creditworthiness of all local governments in the United States. This suggests that Moody’s may downgrade the ratings of many municipal issuers, which would increase their borrowing costs.

The biggest squeeze right now is on variable-rate demand notes, a common form of floating-rate borrowing that is backed by the promise of having sufficient future municipal revenues to repay investors — an increasingly uncertain proposition. The relief money would be used to guarantee these notes.

California, which has been crying the loudest for relief money, is in worse shape than most municipal borrowers. In a May 13 letter to Mr. Geithner, California’s treasurer, Bill Lockyer, said that the state “will be almost out of cash in July.”

Mr. Lockyer added that it is “highly unlikely that the state can access the short-term market ... based on its own credit.”

“We believe that California is not the only state to confront the same short-term cash-flow borrowing needs,” said Tom Dresslar, a spokesman for the California treasurer’s office. “But no one has as great a need as we do in terms of dollars.”

Michael Decker, a co-chief executive for the Regional Bond Dealers Association, concurred.

“All kinds of municipal borrowers are facing revenue shortfalls,” said Mr. Decker. “California is the largest example. Some states are better off than others. But all outstanding debt is backed by tax revenues. And municipalities are facing a greater or lesser level of distress.”

Also clamoring for help is a group of municipalities that purchased Lehman debt, which is now nearly worthless. Legislation authorizing the use of relief money to make these purchases was introduced by two California Democratic representatives, Jackie Speier and Anna Eshoo. If approved, this would be more like a bailout than a guarantee, because the federal government would be paying face value for debt that otherwise has little value.

The price tag on that proposal is around $1.6 billion. The argument promoted by the two congresswomen is that the Treasury and Fed allowed Lehman to fail, causing governmental bodies to lose money.

Though this effort has hit stiff opposition, Ms. Eshoo has not given up.

“It’s been said that some banks are too big to fail,” Ms. Eshoo said in testimony at a May 5 hearing held by Mr. Frank on the issue. “It can also be that counties, school districts and cities are too small to be noticed.”