CHICAGO - The Illinois State Toll Highway Authority last week remarketed $700 million of variable-rate demand bonds with a revised liquidity policy after shedding an insurance policy from XL Capital Assurance Inc. that prompted a spike in interest rates and a failed remarketing.

The deal's struggles during its weekly remarketing cycles were prompted by investor concerns over the loss of liquidity should XLCA face further downgrades. The authority's timing proved astute given Fitch Ratings' downgrade of XLCA's insurer financial strength rating to junk status Wednesday.

Fitch first stripped XLCA of its AAA in late January, downgrading the credit to A. Moody's Investors Service knocked the insurer down to A3 last month while Standard & Poor's downgraded the insurer to A-minus late last month. All warned of further downgrades.

"It became apparent to us with the downgrade of XL that the default provisions of the standby purchase agreement would be triggered with further downgrades" and that would result in the loss of the liquidity facility provided by Dexia Credit Local, toll authority finance chief Mike Colsch said in an interview this week.

The original deal sold in two series, each for $350 million, in the fall of last year. UBS Securities LLCand Banc of America LLC served as remarketing agents. The looming threat, after the initial Fitch downgrade, and later when XLCA lost triple-A ratings from the other two agencies, led to interest rates from the weekly remarketing cycles to rise as high as 7%.

The bond documents included a maximum ceiling of 12%. The authority also experienced at least one failed remarketing. As much as $223 million of tendered bonds were held by Dexia at one point. The authority paid an interest rate of 6% to the bank. The remarketing agents also held portions of the bonds.

"We started working with Dexia and others involved in the transaction to enter into a new agreement that would be based on our underlying credit and not XL," Colsch said.

In order to cancel the insurance and enter into a revised standby purchase agreement with Dexia, the authority needed the approval of bondholders. While most of the bonds were either in the hands of the remarketing agents or Dexia, the authority then proceeded on March 5 to issue a mandatory tender notice.

The authority completed the restructuring process on March 20 when UBS and Banc of America remarketed all of the bonds with the new liquidity agreement, capturing an initial rate of 2%, below the SIFMA floating rate index of 2.33% for that day, Colsch said.

"I was very pleased with the results. It was a difficult process and all the parties worked cooperatively," he said.

Colsch has estimated that the costs of paying the increased interest following XLCA's downgrades at about $3 million. The premium on the XLCA insurance policy that is no longer attached to the bonds was $2 million. The overall borrowing cost associated with the deal however remains within the authority's original planning estimates and the authority has an added cushion of $5 million from savings achieved on its $760 billion advance refunding, which priced in January.

Swaps tied to the deal remain in place. The original issue allowed the tollway to fulfill the terms of forward-starting swaps it entered into about two years ago to lock in the prevailing low interest rates at the time. The tollway is paying a rate just less than 4%.

The swaps were initially based on a percentage of the London Interbank Offered Rate but later as the spread between the Securities Industry and Financial Markets Association's municipal swap index and 67% of Libor swap rates narrowed, the agency shifted to a rate based on the SIFMA index, which eliminated the tax risks that accompany Libor-based swaps.

The authority has a total of $1.7 billion of outstanding variable-rate demand bonds in its $3.1 billion debt portfolio, including portions that carry insurance from MBIA Insurance Corp. and Financial Security Assurance. However, the rates have remained steady on those deals as the liquidity terms lack the same default trigger as the $700 million 2007 transaction did. Those insurers have also maintained their triple-A ratings.

All three rating agencies affirmed the tollway's long-term ratings in the low-double-A category in conjunction with the new standby purchase agreement and the short-term ratings on the deal based on Dexia's credit.

The authority has hedged all of its floating-rate exposure with swaps. Moody's said it views the swap agreements as posing minimal risk to the authority's credit rating because the basis risk posed a mismatch between the variable rate received and the rate the authority pays on its variable rate bonds is manageable. The toll agency also is not required to post collateral and termination risk is remote on most of the swaps.

The authority is working on a new-money issue of about $500 million scheduled to sell this summer. It is issuing new money on an as-needed basis through 2010 to finance a $6.3 billion capital program that includes an overhaul of the 274-mile system. The program relies on $3.5 billion of issuance. Toll revenues secure the authority's debt.

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