SAN FRANCISCO - What do you do if the liquidity costs of your variable-rate debt shoot through the roof? For a strong credit like the East Bay Municipal Utility District in California, the answer was to dispense with liquidity providers entirely.

The district, in the East Bay suburbs of San Francisco, faced the expiration of a liquidity agreement created a year ago when it converted impaired auction-rate securities into variable-rate demand obligations.

The expiring liquidity agreement cost 30 basis points, said Gary Breaux, the district's finance director.

"When we went out for renewals, we got quotes of 100 to 125 basis points," he said.

"Liquidity rates are through the roof," Breaux said. "It's probably to be expected with all the auction rates that were refunded with one-year deals."

EBMUD and its advisers came up with an alternative - no liquidity provision. Last week it priced a $331 million refunding of its subordinated water revenue bonds, with a mandatory tender at one year.

The bonds will pay a variable rate at the Securities Industry and Financial Markets Association municipal swap index - with no spread.

The bonds carry a nominal 2026 maturity allowing EBMUD to keep them integrated with existing interest-rate swap agreements.

As a substitute for liquidity, the district covenants to use "commercially reasonable efforts" to tender the bonds, either through refunding, liquidity, or conversion to another SIFMA-based term interest rate index.

"If they don't refinance it, or take it out with a refinance of some kind, it would be an event of default," said Jenny Poree, vice president at Montague DeRose and Associates LLC, the financial adviser. She compared it to a bond anticipation note.

EBMUD was helped by strong underlying long-term credit ratings: AAA from Standard & Poor's; Aa2 from Moody's Investors Service, and AA from Fitch Ratings.

The deal received tip-top short term ratings of F1-plus from Fitch, VMIG-1 from Moody's, and A1-plus from Standard & Poor's.

"There was a lot of work on the rating agency side," Poree said. "Since this is the first deal of its kind, the rating agencies were very thorough on this."

Investors oversubscribed both series in the issue. Large money funds bought most of the deal, Breaux said.

Morgan Stanley was senior manager on one series, and De La Rosa & Co. the other. The deal closes Thursday.

"We'd hoped to be tied to SIFMA," Breaux said. "To come in flat, we were really thrilled with that."

The next challenge for Breaux: $330 million of commercial paper with a liquidity agreement that expires in April.

He plans to replace it with extendable municipal commercial paper, also without an external liquidity provider. If that extendable paper reaches maturity and the district can't immediately roll it over, the investors agree to hold the paper for an additional 150 days at a higher interest rate.

"That gives us plenty of time to either get it remarketed or fix it out or move it to another mode or get it replaced," Breaux said. "Basically, investors agree to provide us with five months of liquidity." The schedule is structured to keep the paper money-market eligible even if the 150-day extension is invoked.

It would be the first such program in California and one of only a handful in the country, Breaux said in a staff report to the district's finance committee.

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