Combining variable-rate notes and swap lets New York City save 14 basis points.

New York City used an unusual structure and an interest rate swap yesterday to save 14 basis points on a portion of its $650 million offering of tax anticipation notes.

The note structure, which eliminates the need for credit enhancement and pays a floating rate based on the Public Securities Association's municipal swap index, was first used by California on a portion of a $2 billion issue in July.

The structure, designed by Goldman, Sachs & Co., helps issuers reach the widest base of investors for short-term securities, especially money market funds. Such funds are hemmed in by Securities and Exchange Commission regulations limiting their purchases to highly rated short-term securities.

Under SEC rule 2a7, the funds must maintain an average maturity of 90 days or less and cannot purchase any security with a maturity longer than 365 days. The finds can only purchase highly rated short-term securities and must insure that their share price stays at par.

To keep average maturities low, the funds seek out very short-term notes that are repriced every day or every week. But securities with final maturities longer than seven days can qualify as seven-day securities for the funds under certain circumstances.

As a result, most variable-rate short-term securities feature seven-day puts and carry credit enhancement to meet the regulations. But credit enhancement has gotten increasingly expensive. Many of the largest players in that market, including the Japanese banks, are suffering from declining asset quality and falling credit ratings. And for some issuers, like New York City, credit enhancement can be difficult to find at any price.

Goldman's product is set off the PSA index, which is recalculated every seven days. That qualifies the securities for money market funds without the need for a put right.

Combining the variable-rate securities with an interest rate swap lowers the synthetic fixed rate for issuers and still allows the money funds to buy the securities without requiring expensive credit enhancement.

Even though the structure does not carry credit enhancement or a put feature, money market funds are able to buy the notes as seven-day maturity paper. New York entered an interest rate swap, agreeing to pay Goldman a fixed rate while Goldman will pay the city the rate set on the notes.

"This is a repricing mechanism that is okay for the finds and it saves the issuer the cost of the liquidity or credit enhancement," a Goldman official said.

The structure is so unusual that some traders actually discounted rumors in the market yesterday morning that New York would issue variable-rate notes, thinking that the city could not get enhancement at an acceptable price.

Goldman sold $250 million of the notes as variable-rate securities reset every seven days paying interest based on the PSA index.

Goldman officials say the structure has several advantages over traditional variable-rate demand obligations. Demand obligations allow an investor to put the securities back to the issuer at each reset date and carry a liquidity facility to ensure that the issuer will have enough cash on hand to pay all such investors.

In addition to avoiding the costs of credit enhancement, the new securities will be more generic and possibly more liquid in the secondary market.

"These can trade like federal finds notes. There are no limitations from remarketing agents or other agreements," one Goldman official said.

For example, investors holding put bonds generally must notify the remarketing agent before 11 a.m. on the day they want to exercise the put and sell the bonds. The new structure allows investors to seek bids on the notes and sell them at any time during the day.

Money market portfolio managers said they favored the note's unenhanced structure. "We have a lot of exposure to different banks that provided [letters of credit] and liquidity support, so a [note] without backing from a bank is very attractive," one manager said.

In the New York sale yesterday, CS First Boston sold $400 million of the notes due April 8, 1994, at a fixed rate that gave the city a net interest cost of 2.51%. The notes were reoffered to investors at a yield of 2.45%.

Goldman's $ 250 million portion locked in a net interest cost of 2.37% using the new structure. The notes were not formally reoffered.

Moody's Investors Service rates the notes MIG-1, Standard & Poor's rates them SP-1-plus, and Fitch Investors Service Inc. rates them F-1-plus.

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