California notes can get by with a little help from the Feds.

While last week's California warrants deal caused a stir because of the market discount rule, the state averted a similar problem with today's $3 billion note deal with help yesterday from the U.S. Treasury Department. (See related news story).

The state controller's office last week adjusted the payment schedule on its $4 billion of revenue anticipation warrants after it was discovered that they could be subject to possible taxation under the market discount rule should interest rates rise. The Internal Revenue Service requires that securities pay interest once a year or be considered original issue discount bonds. California corrected the problem by adding an additional interest payment.

In the past few days, lawyers Richard Chirls and George G. Wolf of bond counsel Orrick, Herrington & Sutcliffe indentified a January IRS regulation that took effect on April 4, which potentially could have created a similar discount problem for today's issue of revenue anticipation notes. The regulation stated that interest on any security maturing in less than a year would be added to the principal, which in effect would make them zero coupon bonds. They would then be subject to the original issue discount rule that could therefore increase the possibility of taxable market discount income, Chirls said yesterday. The problem was not one that could be corrected by adding an additional coupon payment, he said.

Reacting to California's concerns, the Treasury Department yesterday decided to delay the rule's implementation indefinitely pending further study, he said.

In a statement released yesterday, the California treasurer's office said it was pleased that the Treasury Department responded to its request so quickly.

"The high priority the Treasury assigned to analyzing our inquiry and formulating their decision is enormously valuable to both large and small issuers and investors not only in California, but across the country," State Treasurer Kathleen Brown said in the statement.

"The State of California's proposed $3 billion RANs issuance will go forward as scheduled [today] utilizing the same terms originally contemplated."

Chirls said that not only does the Treasury Department's action affect the RANs deal, but the roughly $10 billion of notes issued since the ruling took effect on April 4. Public Resources Advisory Group is the financial adviser on the RANs deal.

As for the possible tax problems that prompted the California state controller's office to restructure last week's RAWs deal, the controller's office isn't pointing an accusatory finger, a spokeswoman there said Monday. Asked if the state was dissatisfied with the advice it received from either its financial advisor, Evensen Dodge Inc., or its bond counsel, Orrick, Herrington & Sutcliffe, the spokeswoman, speaking on behalf of Deputy Controller Robert Shuman replied: "We are not in the business of assigning blame to anybody. We just want to get the job done."

Some, however, were more critical of the advice California received.

"I think it was a major screwup," a market source who requested anonymity said.

While saying bond counsel Orrick has some responsibility, most of the fault rests with Evensen Dodge, the source said. Regardless of who proposed the structure, it was the financial advisor's responsibility to understand the market implications, he said.

The advisor should have known that going beyond a year without paying a coupon would create an original issue discount situation. In addition, considering the deal's Dutch auction format, the multiple reoffering prices created would have added"insult to injury."

Lastly, the source cited a disclosure problem, adding that he could find no reference in the official statement regarding the possible tax problems.

Orrick referred calls to the controller's office. An official at Evensen Dodge could not be reached for comment despite repeated phone calls.

A source close to the situation said, however that the market discount rule has been around for quite some time, though in 1993 the effect of the rule was increased. Underwriters or funds who had consulted their tax counsels would have learned of the possible tax problem right away because the situation is one tax lawyers are quite familiar with, he said.

In addition, "the issuer has no responsibility in the initial offering to disclose secondary market tax considerations," the source said.

In related action yesterday, Standard & Poor's Corp. said it affirmed the ratings on California's the C and D warrants after the deal was re-structured to include the interim interest payment on July 25, 1995.

The rating agency affirmed the SP-1 rating on the state's $3.9 billion Series C warrants and the SP-2 rating on the $100 million series D warrants.

Turning to the overall market, municipals ended a quiet day unchanged yesterday.

Limited bond fund selling was seen yesterday morning though it picked up during the afternoon, traders said.

"It's not large, it's just very sneaky,"one trader said of yesterday's selling. Roughly four to five lists were out in the morning, another eight to 10 surfaced by afternoon, he said.

"I'd say we saw more in the afternoon,"a second trader said, adding however, "It didn't seem brutal."

Most participants surveyed yesterday cited market lethargy.

"There's a little bit of business going on, enough to keep us busy," another trader said. He added, however, that much of the business was swaps and did little to move the market.

The trader said when people get bored with these levels, they'll move the market on way or the other.

"My bet is down," the trader said, adding that he sees the Treasury's long bond going to 8%. Municipals are going to have cheapen up to attract buyer interest, he said. Right now cash flow into the bond funds remains neutral and the market is too expensive relative to Treasuries to attract crossover buyers, the trader said.

In the primary market, a Smith Barney Inc. group priced and repriced $250 million of sewer system revenue bonds. The offering contained serial bonds priced to yield from 5.25% in 2001 to 6.20% in 2012. Serials from 1997 to 1999 were not reoffered. A 2015 term was priced to yield 6.25%. At the repricing, yields were lowered by five basis points.

"We put in for it," said Sheila Amoroso, senior portfolio manager for the $350 million Franklin Oregon Tax-Free Income Fund, adding that she would not know until today whether she will receive her requested allotment. "It's very well subscribed for at this point.

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