DALLAS - Faced with a diminished market for its variable-rate debt due to lower credit ratings for its liquidity provider, Houston found a rescuer right in its own backyard recently as surrounding Harris County acquired $118 million of bonds that had reset at perilously high rates.

Harris County is earning $682,000 per month in interest on Houston water and sewer refunding bonds that were backed by a standby purchase agreement from Dexia Credit Local.

With investors becoming increasingly scarce due to Dexia's declining credit rating, the bank acquired the bonds at a contractual rate of 15% interest.

To escape that steep interest cost, Houston agreed to sell the bonds to Harris County at a 6.9% rate. The county originally sought 10%, but agreed to lower the cost in negotiations.

"It's unfortunate that they had to pay these rates," said Edwin Harrison, Harris County's director of financial services. "But if they have to pay someone, it might as well be us."

The deal followed an agreement in October in which Houston and the the county's Metropolitan Transit Authority would invest $30 million in each others' debt.

Harrison said the county bought the Houston bonds for its portfolio in a routine surveillance of offerings. The county also recently acquired $76 million of state Veterans Land Board bonds that are paying 9%.

Harrison said that when he saw the interest rate on the Houston bonds, he readily sought to acquire them.

"I was a lot more comfortable with a city I knew so well than if they had been from North Platte, Nebraska," he said. "I knew this was an anomaly in the market."

The variable-rate refunding bonds issued last year were intended as a way to escape auction-rate securities that were resetting at rates as high as 20% when auctions failed. The auction-rate market vanished in 2008, with no issues in Texas. That left Houston holding $1.9 billion of auction-rate securities, forcing a massive refunding effort.

In June, Houston issued the combined utility revenue bonds that completed the refunding of $1.4 billion of water and sewer auction-rate securities. The new bonds were taxable until the call dates of the ARS they refunded. The call dates were Dec. 1, 2008, 2011, and 2012.

The previous ARS were also taxable because they represented a second refunding. Under Internal Revenue Service rules, only the first refunding is tax-exempt.

Houston deputy controller Jim Moncur said that finding the ARS escape route was difficult at the time.

"It was a difficult process because the market kept changing on us," Moncur said at the time. "Between put bonds, [variable-rate demand bonds], and fixed rate, I think we changed our minds about two or three times."

The Series 2008D revenue bonds carry underlying ratings of AA from Standard & Poor's, A1 from Moody's Investors Service, and A-plus from Fitch Ratings. Houston has a general obligation rating of AA from Standard & Poor's and Aa3 from Moody's, with no GO rating from Fitch.

Dexia's Standard & Poor's rating fell from A-plus to A on Dec. 19, 2008, and Moody's downgraded the bank from Aa3 to A1 on Jan. 19. Fitch has a rating of AA-minus.

With the underlying rating higher than that of the liquidity provider, investors did not understand the risk involved in the bonds, Harrison said.

Harris County - which has ratings of AAA from Standard & Poor's, Aa1 from Moody's, and AA-plus from Fitch - holds about $500 million of municipal debt in its investment portfolio, according to Harrison. The fund also includes Treasury debt. The Houston bonds presented a solid opportunity, he said.

"To put it in perspective, this is a security that matures every seven days and is paying 350 basis points higher than a 30-year Treasury," Harrison said. "For a one-week Treasury, this is 680 basis points over that."

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