Philadelphia, a city that once paid almost 25% on a short-term note deal, yesterday found a way to cut that rate to zero.

The city's oversight board agreed to buy $155 million of privately placed Philadelphia notes yesterday, using a structure that will eventually return all of the interest paid back to the city.

The unusual move has the added bonus of letting Philadelphia wait a little longer before risking a return to the credit markets.

The oversight board, knows as the Pennsylvania Intergovernmental Cooperation Authority, will buy the notes using unspent proceeds from a recent $474 million bond issue.

PICA sold the bonds to help the city stay solvent in the face of chronic budget deficits and out-of-control spending, but only about $154 million of the total has been disbursed so far.

The plan is for the rest to be turned over to the city on a predetermined schedule, so the note sale is like "getting an advance" on the bond proceeds, explained Kathryn J. Engebretson, Philadelphia's treasurer.

Without help from the board, Philadelphia would be forced to solve its annual summer cash crunch with another attempt at selling notes in the capital markets. It was the collapse of a note sale in the summer of 1990 that dramatically highlighted the extent of Philadelphia's financial crisis.

Since then, the city has managed to sell other note issues, but only at extremely high rates. One such deal, placed with local banks and pension funds in early 1991, cost Philadelphia taxpayers almost 25% on an annualized basis.

Technically, interest on the private placement approved yesterday will be slightly more than 3.6%, better than Philadelphia could have done if it were forced to enter the market on its own strength, market sources say.

But the actual cost to Philadelphia will be zero, because any interest PICA earns by investing bond proceeds must eventually be returned to the city. In fact, administration officials used that logic to push for a 0% interest rate on the notes right from the start, according to sources involved in the negotiations.

But for a city with a fiscal reputation like Philadelphia's the oversight board decided appearances are as important as economics.

"It looks better and feels better if there's a market rate associated with the investment," said F. John White, the city's financial adviser.

Mr. White, a co-chief executive officer of Public Financial Management Inc., said even though the interest paid will all eventually be returned to the city, structuring the deal at a 3.6% rate signals the market that Philadelphia is capable of repaying a standard note deal.

And that could help convince investors to buy Philadelphia debt when the city decides the time is right for a return to the capital markets, market sources said.

Ms. Engebretson said such a return could occur as soon as this fall, when the next ebb in the city's cash flow is expected. She said no decision has been made, but that deal would probably be between $40 million and $100 million.

The city's treasurer said the interest rate on the current note deal, which closely July 16, was set by examining the rate in the oversight authority could have achieved by investing its bond proceeds in more traditional ways, such as taxable guaranteed investment contracts. She said an attempt was also made to estimate how Philadelphia would have fared in the note market.

Ms. Engebretson said the 3.6% rate was "higher than we could have done in the market," but she noted that the city's private placement will avoid significant issuance costs associated with a standard deal.

But market sources said a Philadelphia note sale would likely cost more than 3.6%, given ongoing uncertainty about the city's new five-year fiscal recovery plan. The plan counts heavily on concessions from city unions, which so far have vowed not to cooperate.

A strike, which city employees had threatened when labor contracts expired July 1, was averted last month when the Pennsylvania Labor Relations Board named a team of "fact finders" to recommend contract terms. The action prevents city employees from striking until Aug. 25. The fact finders are due to release their recommendations on that date, unless they act faster than the 60 days allowed by law.

Mr. White said the city would have paid a market penalty for its labor trouble if it tried a standard note deal but, he added, "I don't think the city would have any trouble accessing the markets now if they wanted. It's just a matter of the most cost-effective" way of borrowing the money.

Gerard J. Keegan, a senior vice president at A. Webster Dougherty & Co. in Philadelphia, said the transaction appears to be a "great deal for the city because they can save millions in interest and issuance costs."

In addition, Mr. Keegan said, "The city doesn't have to worry about how it will do in the market until the labor problem is over."

He said the fact that Philadelphia is paying a market rate for the loan, even though the interest will eventually be returned, shows "good faith."

City Controller Jonathan A. Saidel said he is eager to see Philadelphia return to the traditional market, but added that until then the PICA deal demonstrate Philadelphia's ability to handle short-term debt responsibly.

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