Oct. 7 (Bloomberg) -- Massachusetts scrapped a $750 million offering of short-term notes for the second time in two weeks as turmoil in the credit markets undermined demand.

The state, which asked federal officials for a short-term loan if it can't complete the deal, needs money for expenses as tax collections slow. The average cost to borrow for a year in the municipal market rose to 2.44 percent on Oct. 2, a Bond Buyer index shows, the highest relative to the Federal Reserve's overnight lending benchmark in more than four years.

``We're not going to sell into a bad market when we don't have to,'' said state Treasurer Timothy Cahill in a statement this morning. ``The state's cash position is solid. We will be patient and seek this additional liquidity when we have more confidence that we will get the best price for taxpayers.''

States and cities that borrow in the $2.66 trillion municipal market have struggled to raise money in recent weeks amid upheaval on Wall Street following the Sept. 15 bankruptcy of Lehman Brothers Holdings Inc. Issuers have postponed more than $12 billion in bond and note sales as investment banks and securities firms, facing capital constraints, cut their support for the market, Bloomberg data show.

Scaling Back

The credit clampdown has forced states and municipalities, also crimped by falling revenue from a slowing economy, to cut back on everything from road improvements to school maintenance. Louisiana shelved plans to sell $500 million of bonds this month, while Erie County, New York, has delayed dozens of capital projects.

Cahill said in a CNBC interview yesterday he explored the option of help from the U.S. Treasury and Federal Reserve Bank of Boston before Congress passed a $700 billion financial bailout last week. ``We want to know what kind of options that we might have,'' Cahill said.

The Federal Reserve said this morning it will create a special fund to purchase U.S. commercial paper after the credit crunch threatened to cut off a key source of short-term funding for corporations.

The Treasury will make a deposit with the Fed's New York district bank to help set up the fund. The central bank, invoking emergency powers, will also lend to the program at its target rate for overnight loans between banks, it said in a statement.

`Very Strained'

``Conditions are still very strained in the money market,'' said Joseph Lynagh, a portfolio manager at T. Rowe Price Group Inc. in Baltimore, who helps manage more than $2 billion in tax- exempt bonds. ``Everything is very much day to day.''

The strains are also present in the market for long-term municipal debt, where borrowing costs on tax-exempt debt climbed to a record relative to U.S. Treasuries. Today, the Long Island Power Authority in New York offered $605 million of new bonds due in 2033 at yields as high as 6.25 percent, 2.25 percentage points higher than benchmark 30-year U.S. bonds.

Municipal bonds, down 3.55 percent on average after taking price declines and interest income into account, are on pace for their worst year since 1999, according to Merrill Lynch & Co.'s Municipal Master Index.

California Governor Arnold Schwarzenegger wrote to Treasury Secretary Henry Paulson last week saying he may ask the federal government for an emergency loan. The state is planning to sell $7 billion of revenue anticipation notes, a common form of short- term municipal debt paid back with tax collections, the week of Oct. 13.

Financial Rescue

The financial rescue legislation that President George W. Bush signed on Oct. 3 is supposed to jumpstart the credit market by authorizing the government to buy troubled assets from financial institutions reeling from record home foreclosures. It's unclear whether the $700 billion infusion will work.

Alabama Governor Bob Riley asked the U.S. Treasury to use the Wall Street rescue program to guarantee a $2.7 billion refinancing of Jefferson County's sewer debt, allowing the county to avoid what would be the biggest municipal bankruptcy.

In a letter to Neel Kashkari, who is overseeing the U.S. government's Troubled Asset Relief Program, Riley said the county's financial crisis was ``the single biggest threat to the municipal bond market today and a poster child of how the subprime mortgage crisis is hurting Main Street.''

Tightening Credit

Congress should also offer some form of fiscal relief to states, the Washington-based Center on Budget and Policy Priorities said in a report today.

``States are facing the same problem faced by millions of businesses across the country -- tightening credit markets,'' Nick Johnson, an analyst at the research group, wrote in the report published today.

Massachusetts, rated two steps below AAA, attempted to sell $375 million of notes due in April 2009, and another $375 million set to mature in May. The average cost for states and municipalities to borrow for a year rose 83 basis points in two weeks, according to the Bond Buyer index.

``The signal we hope it sends is to the politicians and regulators that there is a problem here'' in the municipal market that needs fixing, said Robert MacIntosh, a portfolio manager at Eaton Vance Management in Boston, who helps oversee $17 billion in tax-exempt bonds, regarding the delayed sale.

`Cash Cushion'

Massachusetts has a ``cash cushion'' of more than $1.1 billion in various funds that can help it pay expenses through December, Standard & Poor's said this morning in a statement. Cahill's office can also tap up to $1.9 billion from the state's budget stabilization fund if the Legislature approves such a move, the New York-based rating company said.

Governor Deval Patrick, citing a $223 million shortfall in tax collections in the last three months, last week ordered a spending reduction of 7 percent in the executive branch and asked legislative leaders to follow suit.

``The whole credit crunch is certainly affecting the commonwealth and many other issuers,'' said Nicole Johnson, a credit rating analyst at Moody's Investors Service in New York, referring to Massachusetts. ``Hopefully, it's a short-term phenomenon.''

There were some signs of returning stability in the market for long-term municipal debt, where the Long Island Power Authority and Kentucky moved forward with the largest tax-exempt deals in almost four weeks, finding buyers for a combined $980 million of new debt. Issuance today was the most since Sept. 11.

Securities dealers appear to have become more willing to buy blocks of bonds for resale to individuals, attracted by record yields over Treasuries, said Evan Rourke, municipal portfolio manager at M.D. Sass Associates in New York. ``They want to make sure the deals get done.''

``Individual investor interest has been tremendous, to mom- and-pop, trust accounts and other smaller buyers,'' Rourke said. ``We've also seen an easing, but not necessarily a total end, to the selling that had been weighing on the market.''

To contact the reporter on this story: Michael McDonald in Boston at mmcdonald10@bloomberg.net

Last Updated: October 7, 2008 13:21 EDT