VRDO Liquidity Facility?

WASHINGTON - The Obama administration is close to unveiling a temporary liquidity facility for variable-rate demand obligations sold by state, and possibly local, housing finance agencies, knowledgeable sources said yesterday.

The liquidity facility, which would be run by mortgage giants Fannie Mae and Freddie Mac with oversight from the Treasury Department, could be rolled out in the next week to 10 days, said one source briefed on the matter.

The facility would be limited to housing VRDOs, unlike a more general facility that is expected to be included in an omnibus municipal bond bill being drafted by House Financial Services Committee chairman Barney Frank, D-Mass. The facility that Frank may propose to be operated by the Federal Reserve and the Treasury would provide liquidity support to the broader short-term muni market.

Spokesmen for the Treasury, Fannie, and Freddie declined to comment for this story, but the sources, who asked not to be named, said that the facility may initially provide standby bond purchase agreements for mortgage-backed VRDOs and could be expanded at a later date to include letters of credit.

Standby bond purchase agreements cover just liquidity while LOCs cover both credit and liquidity. Typically, LOCs are more expensive but are critical for lower-rated issuers, according to market sources.

The administration also might propose that the two government-sponsored enterprises directly purchase of billions of dollars of muni housing bonds. An early version of the proposal, which sources said has since changed, called for Fannie and Freddie to invest $45 billion in housing bonds issued by state and local housing finance agencies over the next 24 months.

Municipal market participants for the past few months have pushed for the Treasury or the Federal Reserve to provide liquidity to the variable-rate market, citing scarce or expensive facilities from banks that have curtailed providing them at affordable rates to municipal issuers since last year when the auction rate securities market collapsed.

"The idea is to make this a transitional program ... until banks come back," said one source.

The liquidity facility appears to stem from a Feb. 18 speech by President Obama in which he mentioned the need to help state housing finance agencies. In the speech, Obama said his administration would take several steps to bolster the mortgage market, including working "with state housing finance agencies to increase their liquidity."

Fed chairman Ben Bernanke has said repeatedly that his agency does not have the authority to provide liquidity facilities for VRDOs, but Fannie and Freddie already have authority to provide liquidity and credit enhancement to mortgage-backed securities, sources said. Though the two mortgage giants have ceased purchasing munis for their own portfolios, Treasury, which is overseeing their operations, would essentially order them to purchase or commit to purchase these housing-related munis.

It is not clear exactly how many housing-related VRDOs are in existence because the market for short-term debt remains opaque, according to market participants.

Public estimates of the overall VRDO market range from roughly $400 billion to just under $500 billion. Sources said that housing finance agencies have originated a significant portion of that debt.

The Municipal Securities Rulemaking Board launched the initial phase of a short-term transparency system for VRDOs April 1, but the board does not have estimates for the housing portion of the market.

Meanwhile, it is not clear how many of the overall amount of outstanding VRDOs have failed to be remarketed and have been put to their existing bank liquidity providers. Neither the Fed nor the MSRB has reliable figures for the number of VRDO bank bonds, though several market participants noted a November Barron's article said $50 billion of VRDOs had been put to banks.

VRDOs, like auction-rate securities, are long-term securities with short-term interest rates that are reset periodically through programs operated by dealers on behalf of the issuers of the securities. But a distinguishing characteristic of VRDOs is the existence of a "put" or "tender" feature that allows holders to liquidate their positions at par on a periodic basis.

Through the put or tender feature, holders seeking to liquidate a position can put the securities back to the issuer through the remarketing agent after a specified amount of advance notice. If the remarketing agent is unable to find a purchaser for a VRDO, a liquidity facility such as an LOC or standby purchase agreement provides a guarantee against a failed remarketing to ensure that the holder of the VRDO is able to liquidate its position at a price of par. Bonds become bank bonds and revert to high penalty interest rates when they are put to bank liquidity providers.

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