WASHINGTON -- The Harrisburg, Pa., Authority last month redeemed a note issue for a proposed hydroelectric project -- a move that effectively shelved a controversial plan that would have kept alive tax-exempt financing for the project.

But the city of Harrisburg and the authority still plan to try to find a way to use tax-exempt debt to provide permanent financing for the project, an adviser said this week.

"The project is very much alive. We'll be watching the market and considering different financing options,"' said Milt Lopus, president of Devon Capital Services, Inc., an adviser to the authority.

"We'll be looking at the best time and method of issuing permanent financing," Lopus said. The authority plans to finance the project on a tax-exempt basis, he said.

The $390.075 million of notes had been part of a controversial plan to keep alive tax-exempt financing for the dam and hydroelectric project, which was first proposed eight years ago but has not been built because of permit disputes with state officials and widespread opposition from certain state, federal, and industry officials.

The authority redeemed the notes on Oct. 21 with proceeds from the sale of securities that had been escrowed for bonds issued for the project in 1986, Lopus said. The 1986 bonds were refunded with the proceeds of the notes, freeing up the escrow.

The notes were, in effect, a bank loan because they were privately placed with the Pittsburgh National Corp. They were tax-exempt when issued but were eventually rolled over as taxable obligations.

The city of Harrisburg, the beneficiary the notes, lost some money because of the difficulty in getting an investment yield as high as the borrowing yield, Lopus confirmed. But he would not say how much the city lost.

From the time they first surfaced, the notes and financing plan for the project drew complaints from several bondholders, lawyers, and federal regulators.

Bondholders were upset that the city of Harrisburg optionally redeemed the 1986 bonds at par on May 15 after only two weeks notice. Issuers typically give 30 days notice for a redemption. Because of the city's unusually short notice period, at least one bond information service erroneously indicated the bonds could not be optionally redeemed until Nov. 15, 1994. Harrisburg netted about $8.3 million from the redemption.

Bond lawyers and federal regulators were upset at attempts to keep tax-exempt financing alive for the project because, they said, it was not likely to be constructed any time soon, if ever.

In the eight years that tax-exempt financing had been outstanding for the project, the city of Harrisburg had made more than $20 million in arbitrage profits, but increasingly it seemed as though the the project would not be built.

The first tax-exempt bonds for the dam and hydroelectric plant were issued in 1985. They were followed by another bond issue in 1986. The 1986 bonds were remarketed in 1988 and 1991 and redeemed earlier this year.

The $390.075 million of notes was part of a new financing plan that was designed both to keep tax-exempt financing in place for the project and to allow the city to continue to earn money, in this case from the spread between short-term and long-term taxable rates.

A complex transaction was proposed under which the authority would issue about $780 million of tax-exempt and taxable refunding bonds. Both borrowings would have been backed by guaranteed investment contracts which would in effect cross over in about three years. The tax-exempt proceeds were to be used to redeem the notes that had been issued in May. The escrow that had been in place for the 1986 bonds was to be used to acquire a short-term GIC to back the new tax-exempt bonds for three years. The taxable bonds were to be used to acquire a long-term GIC that provides interest on the taxable bonds for three years.

At the end of the three-year period, the short-term GIC that backed the tax-exempt bonds would be used to retire the taxable bonds. The long-term GIC that backed the taxable bonds would be used as security for the tax-exempt bonds and to provide funding for the project and other unidentified as yet city projects.

No money would have been available for any projects during the first three years, but during this time participants of the deal were to reap sizeable profits from the spread between the short-term taxable bonds and the long-term taxable GIC.

Lawyers and federal regulatory officials warned that the proposed deal might have violated tax laws. Standard and Poor's Corp. withdrew its tentative credit rating for the proposed transaction. The underwriter, Commonwealth Securities and Investments Inc., of Pittsburgh, announced a delay in the deal due to "investor confusion" stemming from "negative publicity." But the financing plan was effectively shelved with the redemption of the notes last month.

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