Two senators have introduced a bill mirroring legislation pending in the House that would increase demand for municipal bonds by easing restrictions on the ability of banks to purchase them.

The bill, which was introduced Thursday, by Senate Finance Committee members Jeff Bingaman, D-N.M., and Mike Crapo, R-Idaho, would allow banks to deduct 80% of the cost of buying and carrying tax-exempt bonds issued by states, counties, and local governments whose annual bond issuance is $30 million or less. The $30 million limit would be considerably higher than the $10 million annual issuance limit under current tax law, and would be pegged to inflation.

The bill also includes a "safe harbor" provision that would allow banks to invest up to 2% of their assets in municipal debt without disallowing a proportional amount of their interest expense deduction. Nonfinancial companies already benefit from this safe harbor. The bill is designed to create parity for banks.

In addition, the bill would revise the 1986 Tax Reform Act to remove what some in the market believe is an obsolete barrier to the financing of many projects. The bill would allow the $30 million bond limit to apply to borrowers as well as issuers. This would affect conduit financing, such as bonds sold for borrowers such as small hospitals, schools, and nonprofits by conduit issuers such as their state or city.

"Ten-million-dollar governments are a lot smaller than they were in 1986," said Chuck Samuels, a lawyer with Mintz Levin Cohn Ferris Glovsky & Popeo PC here who is counsel to the National Association of Health and Educational Facilities Finance Authorities. "All this does is recognize that there needs to be an adjustment."

Samuels added that there were few, if any, statewide issuers in 1986 acting as conduits.

"Over the last 20 years we've developed, in most states, statewide authorities," he said. He added that statewide issuers that issue 501(c)(3) debt almost always issue more than $10 million.

"Small governments and small charities would have the ability to create an incentive for the local bank across the street to purchase their bonds, and right now those banks have a disincentive," Samuels said.

The bill, named the Municipal Bond Market Support Act of 2008, heads now to the Senate Finance Committee. However, it could be overshadowed by a backlog of high-profile spending and tax bills that Senate leaders are trying to pass before the target adjournment date of Sept. 26.

Similar legislation that was introduced in June by Rep. Barney Frank, D-Mass., is still pending in the House Ways and Means Committee. Market participants expect that if the legislation passes, it will spur smaller banks to extend credit to more issuers at a time when credit is increasingly difficult for issuers to get.

The Senate bill "is being introduced at a time when the lack of liquidity in the market is hurting state and local government debt issuers," said Susan Gaffney, the federal liaison director for the Government Finance Officers Association. "Increasing that [issuance threshold] to $30 million will help a lot of smaller communities be able to place their debt with their community banks."

Bingaman said during his introduction of the bill on the Senate floor that with long-term municipal issuance in the first half of 2008 dropping 4.1% over the same period last year, it was a critical time to raise the limit on the tax law's "qualified small issuer" exception and thus increase demand. Interest on bank-qualified debt averages 40 basis points less than non-bank-qualified debt, he said.

The bill offered two collateral benefits, he said.

"First, enabling local governments to undertake additional infrastructure investments will help to stimulate our challenged economy," he said. "Second, by enabling banks to acquire municipal bonds - the safest class of security - the bill will enhance the stability of banks at a time that they face considerable financial pressure."

Asked whether the legislation would have its intended effect of sparking more demand for municipal debt, Gaffney said banks probably will be interested in taking advantage of the newly available bonds.

Samuels was hopeful, but with some conditions.

"To be honest with you, in light of everything that's been happening over the last few weeks, months, year ... I think it's somewhat unpredictable what the effect of anything is going to be," Samuels said. "However, in general, everything else being equal, which it's not, this will provide a significant incentive for banks, especially small community banks, to purchase bonds."

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