Oct. 8 (Bloomberg) -- California and other states that need to borrow money for expenses are urging the Federal Reserve and the U.S. Treasury to broaden an effort to alleviate turmoil in the short-term debt markets.

Officials want their tax-exempt securities to be included in a Federal Reserve program to purchase U.S. commercial paper, debt used by companies and governments for day-to-day financing. The Bush administration said yesterday it is reviewing the difficulty states such as California and Massachusetts face selling short-term securities amid a global credit crunch.

Leaving states and cities out ``seems to be a mistake and I hope they will change that and broaden that potential help,'' California Treasurer Bill Lockyer said in an interview today. New York Fed officials told Lockyer today that municipal securities weren't eligible for the Fed program, said his spokesman, Tom Dresslar.

Including tax-exempt borrowers in the program would expand the government's effort to unfreeze credit markets beyond private companies. The $2.66 trillion U.S. market for state and city bonds has been virtually frozen since Lehman Brothers Holdings Inc., weighed down by losses in mortgage-backed bonds, declared history's largest bankruptcy on Sept. 15.

California Governor Arnold Schwarzenegger wrote to the Treasury Department last week to say his state and others may need federal help as tax-exempt bonds are being shunned by investors, leaving governments short of funds to meet expenses while awaiting tax payments.

Trying to Revive

Massachusetts postponed a $750 million offering yesterday for the second time in two weeks. The state, which inquired last week about access to the Fed's short-term loan program for commercial banks, hired Goldman Sachs Group Inc. and Citigroup Inc. to salvage the deal.

``We're trying to cover all of our contingencies as the market continues to be shut,'' said Massachusetts Treasurer Timothy Cahill in a Bloomberg Television interview today. The notes were priced to yield 2.2 percent.

The Fed invoked emergency powers to set up a special fund that will buy top-rated commercial paper. Issuers will be able to sell the debt to the Fed up to the average amount they had outstanding in August, an official said.

The program may be off limits to states and cities because based on existing Internal Revenue Service rules, it might impair the tax-exempt status of their bonds, according to Lockyer and other officials.

``We're looking into this and believe that the program extends itself to governments and are working to confirm that,'' said Susan Gaffney, director of government finance in Washington at the Government Finance Officers Association, a national group of public finance officials.

Notes, Too

States, local governments and nonprofits have sold $26 billion in commercial paper since Jan. 1, 2000, according to data from Thomson Reuters. California has about $1.5 billion of the debt outstanding. Massachusetts failed to complete the sale of $100 million in commercial paper on Sept. 29.

Larger issuers such as California have commercial paper programs -- sold with a range of maturities -- while smaller issuers tend to sell short-term notes, which mature within one year, according to Roger Anderson, executive director of New Jersey Educational Facilities Authority in Plainsboro.

This year alone, municipal borrowers sold $41 billion of notes, according to Bloomberg data, almost 60 percent more than total commercial paper issuance the past eight years. If the federal bailout is to fully benefit the municipal market, it should include notes, he said.

``If I were to meet with Treasury or the Fed I would encourage them to include government notes within the program,'' said Anderson.

On Hold

More than $12 billion of municipal bond and note sales have been delayed since New York-based Lehman declared bankruptcy on Sept. 15, according to data compiled by Bloomberg.

Municipal borrowers also have paid investors record yields relative to benchmark Treasury securities. The Long Island Power Authority in New York offered $605 million of 25-year bonds yesterday at yields as high as 6.25 percent, 2.25 percentage points more than 30-year U.S. bonds.

California, the most populous U.S. state, needs investors to buy as much as $7 billion in notes to maintain its schools, health system and other public services.

`Impossibly Frozen'

Lockyer, a Democrat, said today the state will break up the note sale, offering $4 billion next week and selling the rest when market conditions improve. Bank of America Corp. and Goldman Sachs Group Inc. will manage the deal.

``The credit markets are so impossibly frozen at this moment, we are still a little nervous,'' Lockyer said in a Bloomberg Television interview. ``We're hoping in this state, with the pool of investors that we have here, that we can convince a lot of people to purchase these individually.''

Rising costs in the variable-rate market, where interest rates are reset periodically, have pushed Jefferson County, Alabama, to the brink of bankruptcy as interest rates on some of its sewer bonds tripled to 10 percent.

``States are facing the same problem faced by millions of businesses across the country -- tightening credit markets,'' Nick Johnson, director of state budget and tax system reform at the Washington, D.C.-based Center on Budget and Policy Priorities, wrote in a report yesterday. ``The Treasury or Federal Reserve may have to serve as the lender of last resort.''

Fed Rescue

Congress last week authorized the Treasury to buy $700 billion of bad debt from banks. For states and cities, the obstructed credit markets come as a slowing economy has reduced tax receipts and pushed more government budgets into deficits.

``Even if states get the short-term loans that they anticipate, that won't help them balance their budgets,'' Johnson wrote. ``Unlike the federal government, states can't borrow their way out of a budget shortfall.''

At least 15 states have new budget gaps, Johnson wrote, and 29 have cut spending, used reserves or raised revenue to balance budgets for this fiscal year. More reductions in services or higher taxes are likely in coming weeks, he said.

To contact the reporter on this story: Michael McDonald in Boston at mmcdonald10@bloomberg.net; Jerry Hart in Miami at jhart@bloomberg.net.

Last Updated: October 8, 2008 17:18 EDT