ATLANTA -- Tennessee has broken new ground in the municipal market with the first general obligation note sale to have liquidity support provided by the issuer.

Instead of backstopping a variable-rate issue with a bank letter of credit, the state has agreed to purchase any un-remarketed notes itself, using Tennessee's State Pooled Investment Fund. That fund, which invests money held by state and local governments in Tennessee, currently totals about $1.7 billion.

"This note program is very good for us because it provides the flexibility to schedule borrowings to match funding needs, and because the liquidity arrangement cuts costs," Ann Butterworth, the director of bond finance with the Tennessee comptroller's office, said last week. "We think the concept of using state funds to provide liquidity is an idea that can be successfully used elsewhere."

Ms. Butterworth said one reason other states have not developed similar programs may be because letter-of-credit costs have only recently increased, with the exit of many foreign banks from this business. She said the Los Angeles Department of Water and Power has provided its own liquidity for variable-rate revenue debt, but as far as she knows no general obligation issuer has employed the concept.

"It used to be with Japanese and other banks in competition, you could get an LOC for under 10 basis points -- but now they run at least 20" basis points, she said. "So by providing our own liquidity facility, we could save $300,000 a year on $150 million of outstanding notes. That's not chicken feed."

The state official said the $15.7 million deal priced May 21 by Prudential Securities Inc. is the first installment of up to $400 million of debt that can be sold under the program. The issue was rated MIG1/V-MIG1 by Moody's Investors Service and SP-1 Plus/A-1 Plus by Standard & Poor's Corp.

The next offering, she said, is likely to be sold in September, to be followed by about four sales a year over the next five years. Like all borrowings under the program, the series 1991 A notes will have a final maturity date of May 1, 1996.

The proceeds of the notes will reimburse the state for projects already financed, Ms. Butterworth said, but prospective issues are likely to fund ongoing infrastructure improvements for the state and its agencies.

Tennessee expects to issue bonds from time to time to retire the notes, Ms. Butterworth added. She said the state has said in the prospectus that it would not have more than $150 million of the securities outstanding at any one time.

"These notes were given our highest short-term rating because of the ample funds that are available in the investment pool," said George Leung, managing director of state ratings at Moody's. Mr. Leung said the rating agency was impressed by the size of the fund and its stability. The fund has not fallen below $1 billion over the past five years.

But Mr. Leung noted that the agency will monitor the investment pool closely to see that it remains a viable source of liquidity for the notes.

Mr. Leung said other issuers could use the program, but it may not be that workable in all states.

"In order for it to work, you need not only the large and stable investment pool to provide the liquidity, but also a strong underlying credit and centralized management of borrowing," he said.

Tennessee's general obligation debt, which totaled $594.1 million as of June 30, 1990, is rated Aaa by Moody's Investors Service and AA-plus by Standard & Poor's. The state has not sold GOs since June 1989.

Herb Neufeld, vice president of Evensen Dodge Inc., and Tennessee's financial adviser, agreed with Mr. Leung's assessment of the applicability of Tennessee's note program to other states.

"The problems with using this in other states is simple -- that they are not all triple-A," he said. "But I'm certain we will see other states using this technique at some point -- though with the budgetary strains caused by the current state of the economy, this may not happen quickly."

At Prudential Securities, Gerald P. McBridge, senior vice president and national manager of the tax-exempt division, said his firm has had some conversations with officials in other states about the concept.

"If other states realize the advantages of this approach, I think there may be some more deals like this," he said.

Prudential is being paid a management fee of $ 10,000 for any series of notes less than $50 million and $20,000 for deals greater than $50 million. In addition, the underwriter will receive a takedown of 35 cents per $1,000 of notes. A typical fee would be about 50 to 75 cents per $1,000.

"These are aggressive fees, but obviously we will not do these deals for nothing," Mr. McBride said.

According to the prospectus, Prudential has agreed to purchase and hold for a short period notes that have been tendered but not successfully remarketed. Under such circumstances, the remarketer could be required to hold $100 million of notes for 29 days.

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