Bankruptcy has freed the developer of an Illinois multifamily housing project from a high-interest mortgage, and the guarantor for the municipal bonds issued to finance the loan apparently has no complaint.

Clover Creek Associates, the limited partnership builders of Clover Creek apartments in Lombard. Ill., filed for protection from creditors under Chapter 11 of the U.S. Bankruptcy Code in March. Since then, no mortgage payments have been made to the trustee.

The mortgage default broke a surety bond contract with Continental Casualty Co., the guarantor of Lombard's $32.49 million Series 1985 housing deal, giving Continental the option to accelerate the bonds. But Continental has not done so, even though its interest liability ability grows as time passes.

It appears that Continental will not act before the Dec. 15 put date on the bonds, according to Sarah Webb, vice president of corporate trust at LaSalle National Trust, trustee for the issue. Continental, a subsidiary of CNA/Lowes Corp., has not paid any claims on the surety because the debt service reserves have been drawn down to make the last three coupon payments.

Continental and the developers reportedly are working closely to keep the bonds outstanding. In fact, Clover Creek -- despite being bankrupt -- did just that three months ago by sending cash, not in the form of a mortgage payment, to LaSalle.

"Clover Creek did something surprising last June," Ms. Webb said. "They paid us."

Without the payment, debt service reserves would have been inadequate to cover the coupon disbursal, and the trustee could have declared a bond default -- accelerating the bonds and drawing on the surety bond. Surety bonds act exactly like typical bond insurance, guaranteeing investors' principal and interest.

Officials at Continental declined to comment on any respect of the deal.

A Clover Creek Associates officer attributed the partnership's troubles simply to "overleverage" and a corporate restructuring. She declined to be identified.

The Lombard bonds will undergo a mandatory tender in December, at which point LaSalle will draw on the Continental surety bond to pay investors their principal and the 8 1/8% interest. "Continental will own the bonds," Ms. Webb said.

Normally, Continental would then remarket the bonds at current rates. But it will only do so if revenues are available to support the debt -- a difficult proposition for a company in bankruptcy.

If the rates on the deal are reset, it is possible that the mortgage loan will be renegotiated and Clover Creek will emerge from bankruptcy having escaped 1985's interest rates. In that event, Clover Creek also will have escaped enormous amounts of debt service, thanks to the debt service reserves.

The project itself, meanwhile, appears to be in handsome shape. It has an average monthly occupancy of 95%. And although 20% of the 504 units must be rented to low- to moderate-income residents, the rents fetched for these apartments were high enough for the Clover Creek official to describe the entire project as "market rate."

To qualify for the subsidized units, residents must make less than 80% of the median income for DuPage County. But DuPage is the second-wealthiest county in Illinois, with a 1990 per capita income of $25,000, according to the U.S. Bureau of Economic Analysis.

Ms. Webb said that after Clover Creek Associates defaulted on its mortgage in 1989, LaSalle National Trust officials went to the project to inspect it.

"The project was fully occupied, in good condition, well-maintained," Ms. Webb said. "When we asked them why they defaulted, they said, 'We are not goint to make any payments.'"

Investors yesterday traded the 8 1/8% Lombard bonds at a premium, with transactions slightly above 100 cents on the dollar. The yield to the next put date -- Dec. 15, 1991 -- was calculated at 7.876%. Sources said any price above par is questionable, since the fate of the bonds is far from certain.

The bonds still are not in default. Under the indenture, neither the mortgage default nor the Chapter 11 filing constitute a bond default. The debt service reserves are below the required minimum, according to the trsutee.

Lombard bondholders were thrown a different curveball in May 1991. Anticipating that the debt service reserves would be insufficient to make the June 15 interest payment, LaSalle notified investors it would have to take legal action against Continental to protect the bonds. And it wanted bondholders to foot part of the bill.

The trustee's fees had been paid by Clover Creek, but the partnership was in bankruptcy.

Some investors were outraged, since they deemed LaSalle's fiduciary responsibilities to be a separate issue from who paid the trustee. "This is the first time I have ever seen a trustee ask bondholders to absorb the legal expenses," said an Illinois broker with several retail customers holding the bonds. "It's outrageous."

Several trust officers with extensive municipal bond experience said they had never heard of such a situation. "That's the right thinking," said an officer for a major New York bank. "These court hearings are very costly; lawyers get $300 to $400 an hour, then there's the mailings and notifications -- some heavy expenses.

"I don't have housing deals, thank God," he added. "They're very messy."

Ms. Webb of LaSalle said it no longer appears that bondholders will have to absorb any expenses, since Clover Creek has continued to pay the bank. In May, however, it was unclear where the funds would come from.

"In continuing to represent the bondholders, we weren't looking to take a loss," she said. "A lot of people misinterpreted that notice. It was sent in the remote possibility that we were unable to collect anything from the obligor."

Bondholders, incidentally, agreed to absorb a pro rate share of the expenses.

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