September 22, 2008

The Honorable James L. Oberstar

Chairman, Committee on Transportation

and Infrastructure

U.S. House of Representatives

Washington, DC 20515

Dear Mr. Chairman:

This letter responds to the requirement found in 49 U.S.C. 5323(d), as
amended by the Safe Accountable, Flexible, and Efficient Transportation
Equity Act: A Legacy for Users (SAFETEA-LU; P.L. 109‑59) to establish a
debt service reserve fund pilot program under 49 U.S.C. 5323(d). The Act
directs the Secretary of Transportation to implement the program and to
transmit a report to the House and Senate Committees on the status and
effectiveness of the pilot program.

To date, no applicants have applied for the Debt Service Reserve Pilot
Program; therefore, there is no information to provide on the status and
effectiveness of the program. Enclosed for your reference is supporting
information on the provision included in SAFETEA-LU, reports on
implementation efforts, and identification of possible reasons for the
lack of interest in the program.

An identical letter has been sent to the Ranking Member of the House
Committee on Transportation and Infrastructure and the Chairman and
Ranking Member of the Senate Committee on Banking, Housing and Urban
Affairs.

> Sincerely yours,
>
> /S/ original signed by
>
> Mary E. Peters

Enclosure

**Debt Service Reserve Pilot Program**

**Supporting Information**

**Background**

The Debt Service Reserve Pilot Program (DSRPP) seeks to provide credit
support and reduce overall project expenses by providing public
transportation project sponsors that plan to issue bonds in the capital
markets with the additional flexibility to use Federal grants to
establish and maintain a debt service reserve fund. A debt service
reserve fund provides a supplementary source of revenues that may be
used to meet debt service payments owed to bondholders. It is
particularly useful in the event that the issuer encounters a future
financial shortfall during the debt repayment period that may jeopardize
the scheduled payments to the bondholders. If this occurs, the funds in
the reserve account would be used to make the scheduled payments in full
and on time, a requirement that is important to credit rating agencies
that evaluate the creditworthiness and financial strength of bonds for
the investing public. Credit rating agencies increase the ratings of
bond issues that provide contingent payment arrangements, such as
reserve funds that may be used to meet the obligations of the bond
indenture.

**Program Implementation Efforts**

Implementation of the DSRPP commenced with a notice placed in the
*Federal Register* on December 28, 2006, alerting potential applicants
to the availability of the pilot program and the application procedure.
The limitations included restricting the program to not more than ten
participants. The program was also listed on the Federal Transit
Administration (FTA) Web site and articles were placed in *Innovative
Finance Quarterly*, an electronic publication produced by the Federal
Highway Administration that is delivered to an audience consistent with
the goals of the program. FTA also contacted prospective program
stakeholders in order to ascertain the interest in the program and to
identify potential impediments to implementation.

**Description of the Bond Market**

A bond is an interest bearing security that obligates the issuer to
repay borrowed funds by a specific date and pay interest at a specified
rate. Interest paid by the issuer to municipal bond holders is often
exempt from Federal income tax, as well as State or local income tax
depending on the State in which the issuer is located, subject to
certain restrictions. Consequently, municipal bonds offer a slightly
lower rate to investors to account for the higher after-tax yield
relative to a taxable corporate bond with the same coupon rate.

According to the Municipal Securities Rulemaking Board:

> "There are over 80,000 governmental units that may issue municipal
> securities.[^[\[1\]]{.underline}^](http://www.msrb.org/msrb1/reports/0501v211/discussionpaper12-00--reports.htm#_ftn1%23_ftn1)
> These issuers include not only States and local governments, but also
> many "authorities" that are created to carry out special functions and
> to issue municipal debt. These issuers have outstanding approximately
> 1.4 million different municipal securities, ranging from simple,
> non-callable general obligation debt to conduit financings involving
> complicated credit structures and multiple call features.
> Characteristics such as these distinguish municipal securities from
> U.S. treasuries and corporate bonds, in which far fewer types of
> securities are issued and the securities have more standardized
> features."

A typical transit bond may rely exclusively on Federal grant revenues
for debt repayment (e.g., those issued by the Chicago Transit Authority)
and may utilize bond insurance to guarantee timely payments to bond
holders.

**Program Implementation Progress**

As of May 5, 2008, no applications were submitted for this pilot
program. Several reasons may explain the shortage of interested
participants, and are summarized and explained in greater detail below:

1.  The size of the potential applicant pool;

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1.  Competing financial products that accomplish a purpose similar to a
    debt service reserve fund at a competitive price;

2.  The indifference of credit rating agencies to debt financed versus
    grant financed debt service reserve funds; or

3.  Competition with broker commissions.

The size of the potential applicant pool may limit interest in this
program because only transit agencies that issue debt will be able to
benefit from a debt service reserve fund. Debt issuance involves certain
fixed costs that limit or restrict the use of this type of financing to
large dollar purchases. Consequently, the program may only appeal to
specific transactions that meet specific cost thresholds.

Alternative competing products exist in the financial services
marketplace that may duplicate, mimic or accomplish a purpose that is
identical or very similar to the goals of this program. For example,
bond issuers may choose to protect the integrity of their payment
schedule and the corresponding credit rating by purchasing bond
insurance. Bond insurance guarantees the payment of principal and
interest in full and on time, even in the event of fraud. The issuer is
free to negotiate the terms of the insurance with an underwriter and may
find that it is less expensive to pay a bond insurance premium rather
than maintain a debt service reserve fund. Debt service reserve funds
may involve additional resources such as fund management that may
encumber a bond program. Special tax code compliance requirements, such
as arbitrage rebate calculations and reporting requirements, may
encourage a preference for the relatively simple services provided by
bond insurance.

One of the reasons to use credit enhancement features such as a debt
service reserve fund or bond insurance is to reduce repayment risk and
thereby improve the credit rating of a bond issue, thereby reducing the
interest expense to the issuer. Lower repayment risk represented by a
higher credit rating may augment the appeal of an issue to the investing
public. Many issuers strive to attain and sustain an investment grade
rating in order to expand the market appeal of their issue. In fact,
some investors such as pension funds are restricted by investment risk
management policies or strategies to securities that have investment
grade ratings and must refrain from purchasing any issues that do not
have or maintain an investment grade rating.

However, rating agencies are indifferent in their assessment of how a
particular issue achieves an improvement in its overall creditworthiness
and will give the same incremental rating upgrade to an issue that
relies on bond insurance, as one that utilizes a debt service reserve
fund to ensure timely payments to bondholders. Therefore, the relative
costs associated with these two credit enhancement strategies will
influence the issuer's preference for these products.

Bond insurance firms are able to tailor a policy to an issuer's
individual needs and may therefore displace the need for a less flexible
Federal debt service reserve fund program. Nevertheless, issuers must be
mindful of several unidentified costs of bond insurance. First, premiums
paid to an insurer will never be available to support a public
transportation project in the future, unlike the funds deposited in a
debt service reserve account, which combined with accrued interest over
the life of the fund will be returned to the issuer and may be used for
future public transportation projects. Second, a bond insurer may demand
establishment of a reserve fund as a condition of providing the
insurance. Third, bond insurance does not excuse an issuer from
reimbursing the insurer for the costs of making scheduled payments.

Most bond insurance policies require the issuer to repay the insurer for
making timely payments to bondholders. If the issuer fails to do so, the
insurer will cancel coverage for the issuer and will not provide
coverage for any future debt. In this case, the bonds will enter into a
default condition, which is an extremely rare event in U.S. capital
markets. Finally, it is important to note that bond insurance may not be
available to all issuers, since bond insurance firms may refuse to
insure bonds that they consider to have a speculative risk level.

The financial services industry often provides services on a commission
basis. For bond issuers, it is important to note that an increase in the
size of a debt issue may positively correlate to an increase in the size
of an underwriter's commission. Consequently, there is little incentive
for a financial services firm to recommend a reserve fund financing
mechanism that involves substituting Federal grant funds for funds that
are borrowed as part of an overall debt issue.

**Conclusion**

Due to the lack of interest in this program to date, FTA recommends no
further action to expand the program. Sufficient private sector products
exist that appear to adequately meet the needs of the intended program
recipients. However, it may be useful to continue to permit the option
to use grant funds for debt service reserve requirements in the future.
Recent volatility in the credit markets including the restructuring of
the private firms that provide bond insurance may indicate a future
benefit for debt service resources. Therefore, we do not recommend
eliminating the authority to use Federal transit grant funds for a debt
service reserve fund; credit enhancement options and their associated
costs may change in the future and stimulate an increase in the use of
this authority.