Small Cities Are Turning to Bond Pools to Land Rates like Big Borrowers

By Elaine Johnson Staff Reporter of the Wall Street Journal

Gulf Breeze, Fla., population 6,000, is about to hit the big time in the municipal bond market.

Sometime before the end of the year, the bedroom suburb of Pensacola plans to sell up to $500 million of tax-exempt revenue bonds, an offering that would be considered large for a city of any size, let alone tiny Gulf Breeze.

The issue is an example of the new twist on an old method of municipal finance known as "pool financings". In such offerings, a sponsor, in this case Gulf Breeze floats an issue whose proceeds are used by a number of cities. States have long sponsored similar issues, known as bond banks, but cities have only recently begun to sponsor their own pools.

"It's a new approach to funding local government capitol needs by going with the old, old American way of co-ops - like the farmers' co-op," says Rodney L. Kendig, city manager of Pensacola, which tends to borrow up to $85 million from the Gulf Breeze pool.

'It's Cheap Money'

The pool concept is catching on quickly because it allows similar cities to share underwriting expenses and get the lower interest rates available to large borrowers. "its cheap money," says Errol H. Brick, vice president for Goldman, Sachs & Co., which is lead underwriter and remarketing agent for the Gulf Breeze issue. Cities in California have sponsored pool financings, and the concept is being considered in other states. The Florida League of Cities is also working on an issue separately from Gulf Breeze.

One political roadblock, however, is tax overhaul. Loan pools make use of some controversial financing techniques that Congress may ban or limit beginning the first of next year. While a ban wouldn't prohibit pool financings, it could reduce their appeal.

As sponsor of the issue, Gulf Breeze will administer the loan pool - a task that is expected to net the town several hundred thousand dollars in fees over the 30-year life of the issue. Gulf Breeze also gets first crack at the money, even though the town's needs are modest. City officials have put in for only $2.5 million, which has been earmarked for construction of a community center, expansion of the natural gas system, and other projects. Like each city that participates in the pool, Gulf Breeze is responsible only for the amount it borrows, not for the entire $500 million.

The issue will be composed of variable-rate demand bonds - bonds with 30-year maturities and put features with relatively short lives. A put allows a holder to sell a bond back to the issuer at a predetermined price. The bonds' structure makes them, in effect, long-term issues with the lower interest rates generally found on very short-term notes like tax-exempt commercial paper. The initial interest rate will be negotiated with the purchasers, who are expected to be largely institutional investors.

'Homogenizes the Credit'

One issue with pool financings is the difficulty in rating them because of the different ratings of the individual participants. So polls are invariably insured or back by letters of credit. "Insurance homogenizes the credit," says Mr. Brick of Goldman Sachs.

Two uses of pool financings - advance refunding and arbitrage - are under fire in Congress and may be banned or limited starting next year. In an advance refunding, a city pays off an old issue of bonds with proceeds from a new issue with a lower interest rate. Pensacola, for example, plans to use some of its money from the Gulf Breeze pool to refund outstanding debt. The advance refunding will allow the city to shave as much as three percentage points off its borrowing costs, says Mr. Kendig, the city manager. In arbitrage, municipal issuers can profit by investing some of the pool at a higher interest rate than their borrowing cost.

While pool financings aren't in danger, the threat of a ban on arbitrage and advance refunding could spark a lot of offerings before the end of the year. "A whole lot depends on Congress," says Howard H. Weston, a senior vice president of Arch W. Roberts & Co., Gulf Breeze's financial advisor. "If the new tax bill is approved, why, you're going to have folks standing in line."

Sometime before the end of the year, the bedroom suburb of Pensacola plans to sell up to $500 million of tax-exempt revenue bonds, an offering that would be considered large for a city of any size, let alone tiny Gulf Breeze.