WASHINGTON -- if you ignore a potential problem, it may turn into something worse.

That's what the Internal Revenue Service appears to have done with so-called gray box tax-exempt bond deals in which a credit enhancer ends up with money it can invest without regard to arbitrage restrictions.

In the nearly two years since the controversial gray box structure first surfaced, the IRS has failed to give market participants any formal guidance whether such deals may skirt the government's arbitrage or other tax rules.

Although the IRS started studying gray boxes 18 months ago and reportedly was considering issuing a revenue ruling on their legality, the agency has neither done nor said anything since to tell the market what is good or bad about the deals or specify the parameters for their use.

Backers of the deals, which are most often current refundings of federally insured tax-exempt multi-family housing deals that have run into trouble, argue the issues satisfy the tax laws and help save troubled projects by lowering borrowers' costs through the use of credit enhancement.

But critics say the structure of the deals, which appears to be a takeoff on the "black box" deals of the mid-1980s,is a charade designed to set up a sinking fund that is sheltered from arbitrage restrictions. Or they charge the bond proceeds are being used to acquire higher-yielding investments, such as investment property, and the bonds could be declared taxable.

Some bond attorney feel gray boxes, which may involved reputable U.S. credit enhancement firms, may be legitimate. But others feel the structure invites abuse.

While the IRS has been sitting on its hands trying to decide what to do or say about gray boxes, bond lawyers say they are seeing more and more market participants trying to use credit enhancement devices to shield arbitrage investments.

Now some clever market participants have taken the essence of the gray box structure to an extreme by creating what should be dubbed "shadow" box transactions.

Rather than providing real insurance for the bonds, the company providing the credit enchancement appears to end up serving as a front to earn arbitrage.

The first specific example of these variations on the gray box theme to be identified is spotlighted by Washington Bureau reporter Lynn Stevents Hume in a story that appears on the front page of today's issue.

The deal is a $3.9 million junk bond issue that was sold by the Marengo County, Ala., Port Authority, then insured, and resold a day later for $20.5 million. The transaction appears to have been arbitrage driven and designed to bail businessmen out of a financially troubled marina while reaping huge profits for participants, but the participants deny the deal violates tax law or improperly benefits anyone.

Since the 1989 deal, bond lawyers say they have seen a half dozen similar deals in the market. Some fear more will surface if the IRS continues to drag its heels in determining what circumstances, if any, the gray box structure and any variations are acceptable.

While the transaction has been widely discussed and challenged by several bond lawyers at public meetings, the IRS does not appear to have investigated it.

As Ms. Hume painstakingly explains, the transaction revolves around a private insurance company or partnership that had no credit rating and few assets that provided a "credit enhancement" for municipal junk bonds.

The bonds were then rated triple-A and reoffered to investors at premium prices. Most of the profits from the reoffering were indirectly used to pay the credit enhancer, which then invested that money in high-yielding securities to back the bonds, Ms. Hume shows.

Most lawyers and industry officials who reviewed the bond documents -- including officials from major U.S. bond insurers -- said that rather than providing a true credit enhancement that reduced the issuer's borrowing costs, the credit enhancer was setting up an invested sinking fund that guaranteed the payment of debt service. As a result, the credit enhancer earned arbitrage that was not available to the issuer, which would be subject to yield restriction requirements under the tax laws, they said.

The shadow box transaction uses the shadow insurance to do what an issuer could not do -- set up a sinking fund that earns more than the bonds yield.

And much like the black box deals of the mid-1980s, the shadow box transaction is set up so that the bondholders will be paid even if the project fails.

This guarantee, of course, comes at the expense of the nation's taxpayers because the transaction resulted in five time more bonds being issued than were necessary to pay for the project.

Fortunately, reputable bond counsel are strongly advising clients not to get involved in shadow box deals. They fear that issuers could find themselves in a situation similar to the mid-1990s, when the stampede of abusive black box and escrow deals prompted the IRS and Congress to launch a crackdown that still haunts the market.

But self-policing can't be relied upon indefinitely.

If the shadow box technique starts to take off, there could be another stampede that might trigger a heavy-handed response from Congress that might sweep up legitimate financings that use credit enhancements as well as those that are arbitrage-driven.

That's why it's past time for the IRS to sort out the use of both gray boxes and the new shadow box techniques.

Then the IRS should clarify what is legal and what isn't.

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