Letters of credit (LOC) can be used to reduce the borrowing costs for state and local governmental issuers. LOC providers, typically banks and other large financial institutions, extend their financial strength to the issuer for a fee. This enables the issuer to achieve lower borrowing costs than if it offered securities through its own credit. LOCs can be particularly helpful as a source of liquidity for small issuers who do not have high bond ratings or large bond issuances. LOCs are also useful to issuers of every size as a mechanism to diversify access to the credit markets through large, well known institutions in order to place low cost variable rate securities such as variable rate demand bonds (VRDB) or commercial paper (CP).

The FHLB System is a government sponsored enterprise (GSE) consisting of twelve cooperatively owned nstitutions that are regulated by the Federal Housing Finance Board. Ownership of the individual FHLBs consists exclusively of banks, savings institutions, credit unions, and insurance companies. FHLB debt is not explicitly guaranteed by the federal government.

In 1984 Congress banned so-called “federal guarantees” of tax-exempt bonds but exempted a number of government sponsored enterprises (GSEs) who could issue LOCs including Fannie Mae, Freddie Mac and others. At that time, the FHLBs did not attempt to have themselves added to the exempt list for several reasons. First, these banks were not issuing many LOCs for tax-exempt bond transactions.1 Second, they did not believe that this type of transaction would be considered a federal guarantee since the federal government does not back the FHLB.

After banks who were members of the Federal Home Loan Bank System began issuing letters of credit, the IRS ruled that these letters of credit were considered federal guarantees. Thus, the FHLBs had to cease issuing LOCs, (and some transactions had to be reconfigured) in order to avoid jeopardizing the tax-exempt status of the bonds.

GFOA Position
The Government Finance Officers Association supports legislation that would add the Federal Home Loan Banks System to the list of exempted government sponsored enterprises, thus allowing the Federal Home Loan Banks members banks to offer letters of credit to all tax-exempt bond issuers. More options in the guarantor market are beneficial for issuers and investors alike.

• Publication date: June 2008