Local housing authorities are using a new structure that includes selling a derivative security to lower their issuance costs.

After a housing bond issue is sold, the issuer usually has up to three years to loan out the money to home owners. If the money isn't loaned out, some or all of the bonds are called.

The housing authorities loan out the money at rates slightly above the rates they pay on their bond issues. These rates compete with commercial mortgage rates available from other lenders.

If rates fall after the bonds are issued, the authority won't be able to offer attractive rates and home owners will opt to borrow from commercial lenders.

Despite the demand for bonds, some of the smaller housing authorities have another problem: the steep yield curve. The steep curve can create losses for a housing authority in the first few years of a bond issue.

Ultimately, the home owners' mortgage payments will be used to make debt service payments on the bonds, although the mortgages may be repackaged into triple-A rated securities backed by the Government National Mortgage Association.

But for the first three years, before all of the loans are made, the issuer must cover the bond interest on its own. The bond proceeds waiting to be loaned out can be invested, but usually at low, short-term rates that don't cover debt service on the bonds.

To minimize this loss, known as negative arbitrage, some issuers are using a new structure that includes selling a derivative security.

"Local agencies don't always have money to feed all this negative arbitrage," said David Rubin, managing director and chief executive officer at Chambers, Dunhill, Rubin & Co. Rubin's firm has helped issuers and regional firms put together 17 bond issues this year that eliminate the arbitrage losses. Undewriters using the structure include First Southwest Co., Lewis, de Rozario & Co., and George K. Baum & Co.

"The objective of the program is to eliminate an issuer's negative arbitrage during the acquisition period while still providing an attractive loan alternative to conventional single family loans," said Gary Killian, a managing director at Lehman Brothers. Lehman has participated in the deals not as an underwriter but by providing and arranging needed investments and services.

The deals have three twists.

First, an issuer buys a three-year guaranteed investment contract instead of investing bond proceeds in short-term investments.

Using a longer-term investment reduces the issuer's losses before the money is loaned out from 100 or more basis points per year to about 30 points, according to housing bond experts.

But the bond proceeds are then locked up for three years. How does the issuer make any loans?

The answer is that the second part of the structure involves a repo-like transaction called a warehouse. A warehouse provider, such as a Wall Street firm, agrees to loan money to the issuer to make mortgage loans for the first three years of the deal. In return, the issuer agrees to lend the warehouse provider the GNMA securities that the mortgages go into.

But using the three-year GIC and the warehouse still leaves some negative arbitrage.

That's where the derivative, an interestonly strip, comes in.

Housing issuers are allowed to make mortgage loans at a rate up to 1.125% above the rate on their tax-exempt bonds. But often the issuer does not charge the full spread. After fees and expenses, there may be another 40 or more basis points of interest that could be added in.

To cover the remaining negative arbitrage, the issuer agrees to charge the full 1.125% spread and then sells that extra stream of interest, 40 basis points a year over the life of the bond issue, up front in the form of an interest only security.

The upfront payments covers the negative arbitrage and provides money to pay for the cost of issuing the bonds.

If the issuer cannot loan most of the bond proceeds within three years, however, the holder of the interest-only security will receive a dramatically reduced stream of money and potentially big losses.

Lehman has provided warehouse services and GICs on some of the deals through Assured Return Management, a triple-A rated company set up by Lehman with outside investors. And the firm has bought the IO securities on all of the deals, Killian said.

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