April 17 (Bloomberg) -- U.S. state and local borrowers burned by the collapse of the auction-rate bond market are bidding on their own securities in an attempt to bring down interest costs that soared as high as 20 percent.

At least three dozen municipal debt issuers, from the 216- bed All Children's Hospital in St. Petersburg, Florida, to Puerto Rico, are taking advantage of Securities and Exchange Commission guidance allowing them to bid if they publicly disclose their intent and show the offers aren't below-market. All Children's used its funds to cut the rate on about $62 million of the pediatric hospital's auction debt to 1.80 percent yesterday from as high as 11 percent in February.

``We had to get out of this environment,'' Arnold Stenberg, the chief financial officer of All Children's, said after the hospital dipped into its $450 million of reserves to bid.

The decline in interest costs has come at a price for municipal borrowers, who are taking out loans at a time when the economy is slowing or using cash that would otherwise be available for medical equipment upgrades, school supplies or road repairs.

For two decades, auction-rate bonds allowed local governments, hospitals, and closed-end mutual funds to issue debt maturing in as long as 40 years at short-term rates that reset every seven, 28 or 35 days through bidding.

Subprime Fallout

Investors and dealers began to abandon the $330 billion market in February on concern that creditworthiness of companies insuring the bonds was deteriorating because of losses they took guaranteeing debt backed by subprime mortgages.

More than two-thirds of auctions failed, data compiled by Bloomberg show, and the average rate on seven-day securities shot up to 6.89 percent on Feb. 20 from 3.63 percent a month earlier, according to the Securities Industry and Financial Markets Association. When an auction fails because of lack of demand, rates are set at a ``penalty'' level determined at the initial bond offering and holders are stuck with the securities.

Borrowers and dealers appealed to the SEC for help, and on March 14 the agency issued guidance allowing municipalities to bid on their bonds as long as they disclose their intention two days in advance of an auction. They must also disclose the rate they plan to bid and the amount of securities they're seeking.

Issuers also need to ensure bids weren't below a market rate -- such as Sifma's municipal swap index, a gauge of yields on top-rated, seven-day tax exempt variable rate demand notes -- and they must disclose the auction results.

`Clear Path'

``You had a group of investors and issuers who wanted to undo the whole thing but didn't have a clear path to undo it,'' said Paul Maco, a partner at Vinson & Elkins LLP, and the SEC's first director of the Office of Municipal Securities.

The average seven-day rate fell to 5.14 percent as of April 9, as ``recent bids by issuers have had an especially large effect on very high-rate failed auctions,'' Merrill Lynch & Co. municipal strategist Philip Fischer said in an April 11 report.

Before the regulatory guidance, dealers were reluctant to accept bids from municipal issuers for fear of violating a May 2006 settlement with the SEC over improper bidding practices, said John McNally, a partner at Hawkins Delafield & Wood LLP in Washington. Goldman Sachs Group Inc., Citigroup Inc. and 13 other firms paid $13 million to settle claims they rigged bids in the supposedly blind auctions. The banks neither admitted nor denied the allegations.

Manipulation Concern

``There was a concern that it might be market manipulation for an issuer to enter a bid that could influence the price at which the auction occurred,'' said McNally, who serves on the board of directors of the National Association of Bond Lawyers, a municipal bond attorneys' group.

Not all borrowers waited for the SEC's guidance to participate at auctions. Florida's Citizens Property Insurance Corp., the state's largest property insurer, started bidding on a portion of its $4.5 billion of auction-rate bonds at the end of January. Some of its taxable debt reset at yields as high as 15 percent.

``We absolutely consulted with our outside counsel,'' said Citizens Chief Financial Officer Sharon Binnun. Dealers running Citizens' auctions, including Bear Stearns Cos. and Goldman Sachs Group Inc., didn't balk at accepting bids, she said.

The insurer, which issued auction-rate debt to raise money to pay claims in the event a hurricane strikes Florida, has acquired $2.7 billion of its bonds so far, using cash on hand, Binnun said.

Puerto Rico

Puerto Rico started bidding on its $643 million of auction debt April 3 after interest costs jumped to as high as 12 percent in February, officials said. The effort helped lower the average rate on the bonds to 2.75 percent from about 6.15 percent before the U.S. commonwealth stepped in, a savings of about $400,000 a week, they said.

``Our initial reaction was that something is not right in this picture,'' said Jorge Irizarry, president of Puerto Rico's Government Development Bank. ``Definitely there was a spike and we are not going to recoup it completely,'' he said, referring to the extra interest Puerto Rico had to pay from the higher rates.

BayCare Health System, which has nine hospitals in Florida's Tampa Bay area, bid at the Sifma rate plus 1.23 percentage point using money it obtained by tapping a credit line.

``The investor needs to get some kind of liquidity premium,'' said Tommy Inzina, 49, BayCare's chief financial officer.

Interim Solution

Bidding is an interim solution for many borrowers to prevent failures and keep rates down while they replace auction debt with other types of bonds. States, cities, hospitals and colleges have converted or are planning to replace at least $43.1 billion of the securities by next month, Bloomberg data show. Puerto Rico plans to convert its auction debt by the end of the month.

The prospect of additional supply weighed on conventional municipal bonds. The average yield on 10-year tax-exempt debt rose to about a half-percentage point more than taxable Treasuries of similar maturity last month. The yield averaged about 0.63 percentage points less than government debt between 2001 and the end of last year.

All Children's bid on its auction debt on March 26 after working for 10 days to draft disclosure documents, determine a rate and set up an account with Charlotte, North Carolina-based Wachovia Corp. to buy the bonds, Stenberg, 54, said.

The hospital bought $37.25 million of the debt after bidding at the Sifma municipal swap index rate of 2.33 percent, about 5 percentage points lower than the previous week's winning bid and 2.42 percentage points less than the next-lowest bid, results of the auctions show. It now holds more than $46 million of the bonds.

``It was initially a challenge to get through all of the required disclosure process and where to collect all the information,'' Stenberg said. ``At this point it goes pretty smoothly.''

To contact the reporter on this story: Martin Z. Braun in New York at mbraun6@bloomberg.net;

Last Updated: April 17, 2008 09:39 EDT