WASHINGTON -- The new arbitrage rules will discourage issuers of single-family mortgage bond and student loan bonds from "cross-calling" bonds to lower borrowing costs, several bond lawyers said this week.

An issuer that "cross-calls" uses repayments of the low-yielding loans financed by one bond issue to call some of the high-yielding bonds from another issue. The issues are secured by the same pool of loans.

The new arbitrage rules. however, contain a universal cap under which single-family mortgage and student loan bond issuers cannot have more investments than they have outstanding bonds for each bond issue.

In other words, if an issuer cross-calls or redeems high-yielding bonds, but not the loans financed by those bonds, the high-yielding loans that were financed with those bonds become allocated to lower-yielding bonds.

In such cases, the issuer may wind up with investments that have higher yields than their bonds. If the spread between the yields of the bonds and loans is greater than the spread permitted for such bonds under the tax law, the issuer will have an arbitrage problem unless it forgives some of the loans, rebates arbitrage profits, or makes yield reduction payments to the federal government.

Proponents of cross-calling warn that the universal cap could put a halt to the practice.

But they do not believe that federal officials intended the new arbitrage rules to have that effect and they want the Internal Revenue Service to exempt single-family mortgage and student loan bond issuers from the universal cap.

"By imposing the universal cap, federal officials have taken a position that will effectively preclude cross-calling, which has been a common industry practice," said a lawyer in a western state who did not want to be identified. "I don't think they realized they were doing that," he said.

He and other lawyers contend that when several bond issues are secured by the same pool of loans, the money from prepayments or repayments of the loans is fungible and can be used to call any of the bonds.

The Treasury and the IRS should favor a practice under which higher-yielding tax-exempt bonds are called early, they say.

But without an exemption from the universal cap, the western lawyer said, "State agencies will not be able to take loan prepayments and use them to retire high coupon bonds as easily as under the old arbitrage rules. The high coupon bonds will remain outstanding longer."

Critics who either oppose cross-calling or approve of it only under certain conditions say, however, they are not worried that the new arbitrage rules will discourage cross-calling in some cases.

"It's leading everyone into the same place where we already were," said a West Coast lawyer who also did not want to be identified.

The lawyer said his firm contends that a refunding results when the proceeds of one issue, which financed loans, are used to redeem higher-yielding bonds from another issue. The remaining loans that were financed with the higher-yielding bonds, in effect, become pledged to repay lower-yielding bonds and must be yield-restricted to the yield of those bonds, he said.

IRS officials say they have no policy on cross-calling and have not tried to address it directly in tax regulations.

"It's not really addressed," said one IRS official.

But they agree with bond lawyers that the universal cap in the new arbitrage rules could discourage cross-calling of bonds.

State housing authority officials interviewed this week said they were not sure whether they had engaged in the practice of cross-calling or not.

They said that whenever possible they try to recycle the money from prepayments or repayments of loans into new loans.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.