CHICAGO - The Illinois Student Assistance Commission as soon as Thursday will enter the market with a unique tax-exempt $50 million sale of student loan revenue bonds that along with a federal guarantee of 97% on the underlying loans will carry the full faith and credit pledge of the state of Illinois and monoline insurance.

William Blair & Co. and Cabrera Capital Markets LLC are co-senior managers and Grigsby & Associates Inc. is the sole co-manager. Scott Balice Strategies is financial adviser, Foley & Lardner LLP is bond counsel, Perkins Coie LLP is underwriters' counsel, and Chapman and Cutler LLP is issuer's counsel.

The commission will use proceeds of the bonds, which are exempt from state and federal taxes, to purchase a portfolio of so-called rehabilitated loans held by the Department of Education after the loan recipients defaulted. Under the DOE's loan rehabilitation process, loan recipients who meet certain criteria and make good on payments for a nine-month period are eligible for rehabilitation.

The process can't be completed, however, until the loans are purchased from the federal government. That final step has been hampered because agencies that partner with DOE to administer the Federal Family Education Loan Program, like ISAC have been unable over the last year to raise the capital needed to purchase the loans amid the international credit crunch and distaste for asset-backed securities at an affordable interest rate.

The state-guaranteed bonds will carry a final maturity in 2014 with collateral coming from the portfolio of loans ISAC will purchase. The Department of Education will provide reinsurance for 97% of the debt and the bond indenture calls for a 4% debt service reserve with 75% of the funds coming from bond proceeds and the remainder from ISAC cash on hand.

ISAC reserves the right to prepay the bonds after 2010. Cash flow from repayment of loans will first go to cover interest, then principal, said John Sinsheimer, ISAC's chief financial officer.

The state is currently rated A1 by Moody's Investors Service, and AA-minus by Fitch Ratings and Standard & Poor's. Fitch has the credit on negative watch. Assured Guaranty Corp. will provide coverage. Fitch downgraded the credit last week to AA with an evolving watch, while the credit retains its AAA and stable outlook from Standard & Poor's. Moody's rates it Aa2 and stable.

The agency had explored financing options with its investment bankers over the last nine months but any securitization including a private placement without state assistance would be too costly, likely landing in the double-digit interest range. The loans themselves carry rates between 4 and 6%.

"There has been such tremendous risk aversion, across all asset classes," said Andrew Davis, ISAC's executive director, even though the loans carry a 97% federal guarantee.

"Ultimately, we saw that the only place where the capital markets - besides the Treasury market - was still working was the municipal market even if it was at slightly higher rates," Davis said.

ISAC officials are hoping that the multiple layers of enhancement and the exemption investors will receive on bond interest from federal income taxes, the alternative minimum tax, and state taxes will attract strong retail interest. The state awarded the private-activity bonds a portion of its private-activity volume cap to allow for the federal tax exemption and student loan debt is one of the rare forms of state paper that carries a state tax exemption.

"This should be a very attractive bond," Sinsheimer said. Even with the various credit wraps, the bonds likely will require some premium and capture a rate in the low 3% range.

The sale represents the first time Illinois has put its GO pledge behind a student loan-related deal. ISAC officials and market participants said the deal to purchase only rehabilitated student loans is also a rarity in the country.

The ISAC board signed off on the documents at a meeting Thursday. Gov. Pat Quinn held a formal bill signing ceremony on Friday on SB 325, approved by the General Assembly late last month allowing for the use of the state's GO pledge.

"During the current credit crisis, I am pleased the Illinois Student Assistance Commission will assist those who have defaulted on student loans but have seriously tried to make amends and repayment," Quinn said.

ISAC officials said at least 3,500 loan holders will be helped by the transaction. In addition to clearing their credit records, the loan holders are once again eligible to apply for federal aid and loan assistance. Taxpayers benefit because the loans are being repaid and ISAC benefits because it relies on fees from the federal government for a good chunk of its $40 million annual operating budget.

ISAC in 2007 sold off about $3 billion of its student loan portfolio. The agency, like many other student loan authorities, saw its auction-rate securities fail a year ago when that market collapsed, but the rates remain favorable on the $880 million portfolio because the bond documents limited the failed rate to 1.20% over the 90-day Treasuries.

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