Alternative sources of credit enhancement outstripped letters of credit in the year's second quarter, and domestic banks continued to make inroads as credit providers, according to a recent report from Moody's Investors Service.

Of issues rated by Moody's in the second quarter, those backed by letters of credit totaled $1.7 billion, a 65% rise from $1 billion in the first quarter.

However, the $2.7 billion of LOC-backed issues rated by Moody's in the first six months of the year represents an 18.2% decline from $3.3 billion in the first half of 1993.

Rising long-term interest rates and the desire of many issuers to balance their portfolios with variable-rate debt after two years of long-term fixed-rate refundings have fostered a renewed interest in short-term borrowings. However, the use of letters of credit in the first half of the year trails the pace for the same period last year, thanks mainly to the growing use of alternative credit enhancement vehicles, Moody's said.

Moody's said that, in a "general shift" that had built for several quarters, alternative forms of credit enhancement outpaced letters of credit in the second quarter while matching their output in the first half of the year. Issues backed by alternative credit supports -- such as insured floaters, and liquidity-supported and unenhanced variable-rate demand notes -- totaled slightly more than $2 billion in the second quarter and $2.7 billion for the first six months of the year, the report said.

"Institutions Continue to seek alternatives to LOCs primarily because of their lower cost and their historically stable long-term ratings when compared to the ratings of banking institutions," the report said.

Despite the predominance of alternative credit mechanisms, Moody's said the "most significant development" of the second quarter was the growing use-of letters of credit issued by U.S. banks.

In providing enhancement on 29 deals totaling $849.8 million, domestic letter of credit providers more than doubled their output from 1994's first quarter, when they backed 15 deals worth $362 million, Moody's reported.

U.S. banks are "financially healthier now and have an appetite for new business," the report said, noting the growing activity of regional banks.

For example, CoreStates Bank and PNC Bank each supported a $75 million Series of Philadelphia's recent issue of tax and revenue anticipation notes.

Clarence D. Armbrister, Philadelphia's treasurer, said the desire to support. local institutions "to the extent we can" contributed to the city's decision to use CoreStates and PNC, but there are also economic advantages to using regional banks.

"We found in the marketing of our TRANs great demand in the financial community for [issues backed by] quality, but not as widely known banks," Armbrister said. "A good-quality regional bank that might not have the breadth of exposure we found to be a very significant tool in our arsenal."

The reason, he said, is that money market fund mangers must comply with capacity limitations on individual letter of credit providers. In light of those limitations and proposals to tighten them further, many fund managers are now eager to find issues backed by smaller regional banks, which have not been particularly active in public finance in recent years.

In the first half of the year, U.S. banks provided backing on $1.2 billion of issues rated by Moody's compared with slightly more than $1.0 billion in 1993.

Japanese banks, in contrast, continue to see their market share slip. Once the dominant providers of letters of credit, many Japanese banks are still troubled by credit quality deterioration and as a group provided LOCs on only $201 million of issues in the first half of the year compared with $950 million the year before.

Led by the Swiss banks, the European providers maintained their strong presence in the municipal market, issuing letters of credit on $1.3 billion of issues in the first two quarters of 1994, in line with $1.4 billion last year.

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