May 22 (Bloomberg) -- While New York’s Legislature and governor attempted earlier this year to close a $17.7 billion budget gap by raising taxes and eliminating 8,700 jobs, the comptroller’s office gave away almost $1.4 million from taxpayers in the bond market.

The state, without bothering to take advantage of market interest rates, paid face value for auction-rate bonds in February and March when the same debt traded at discounts of as much as 40 percent, Municipal Securities Rulemaking Board prices show. The securities, maturing in 2011 and 2022, are part of $1.13 billion of auction-rate debt New York has remaining, which it might be able to repurchase at a discount of 10 percent, according to Kevin O’Connor, a managing director at New York- based Secondmarket.com.

The potential savings from buying auction-rate bonds at a discount would have covered the annual salaries of 27 psychiatric nurses, according to the state’s civil service Web site. Instead, the beneficiaries were the institutions responsible for the 2008 collapse of a market that tied up $330 billion of securities, creating losses for taxpayers across the country.

“There’s supposed to be somebody in budget managing the structure of the state’s debt,” said Senator Kemp Hannon, a Republican from Garden City and a member of the Senate Finance Committee. “They should be using their intelligence to save the state money.”

New York Governor David Paterson said this week he is preparing for a $3 billion deficit in the annual budget he and lawmakers approved last month. His spokesman, Errol Cockfield, referred all questions about the auction-rate debt to the New York Division of Budget.

State Officials

“There are legal and investor relations issues involved, and we are reviewing these issues,” said Jeffrey Gordon a spokesman for the Division of Budget, in an e-mail.

The New York Comptroller’s office, which handles some state securities, including the two issues partially redeemed in February and March, regularly reviews the debt “with the long- term goals of maintaining ready access to the capital market at the lowest practical overall cost,” said Robert Whalen, a spokesman.

Patricia Warrington, head of the comptroller’s Bureau of Debt Management declined to be interviewed. Dominic Colafati, a chief budget examiner who oversees New York state debt policies, declined to discuss the state’s options.

Benjamin Asher, senior managing director at New York-based Public Resources Advisory Group, an adviser to the Division of Budget and comptroller’s office for bond sales or swaps, didn’t respond to questions sent by e-mail or telephone. Public Resources has collected $1.27 million from the state since July 2005, according to state comptroller’s records.

Market Collapse

Auction-rate securities are bonds and preferred stock with interest rates reset through sales every seven, 28 or 35 days. Auction failures accelerated in February 2008 when banks, beset by mounting losses tied to subprime mortgages, stopped buying bonds that went unsold at the auctions they conducted. Dozens of continue failing daily, Bloomberg data show.

The collapse stuck investors with securities they couldn’t sell and borrowers with penalty interest rates of 20 percent or more. State regulators and the Securities and Exchange Commission have recovered more than $57 billion for investors through settlements with banks, according to data compiled by Bloomberg.

Underwriters including Zurich-based UBS AG and Citigroup Inc. of New York advised the state in the sale of auction-rate bonds in 2001 to 2005 in an effort to obtain lower borrowing costs, according to bond sale documents and state budget reports. They were among dealers forced to buy $67 billion of the bonds last year from individuals misled by claims that the securities were cash equivalents, settlement documents show.

‘Pay Face Value’

The purchases made banks the biggest holders of auction- rate bonds and put them in a position to benefit when issuers buy the debt at face value, according to O’Connor, whose firm acts as a middleman for trades in auction-rate bonds.

Because banks have already marked down the value of the securities on their own books, accounting rules let them record a profit when the bonds are refinanced or redeemed at 100 cents on the dollar.

Anticipation that government issuers will pay face value is keeping prices higher than they would be otherwise, said O’Connor, a former banker who helped start the auction-rate bond trading desk at New York-based JPMorgan Chase & Co. in 2000.

“Banks want the issuers to pay face value,” he said.

Paying Face Value

Besides New York, government borrowers paying par for auction-rate bonds that previously traded at lower prices include Jefferson County, Alabama, which is on the brink of a possible bankruptcy, and hospitals in Illinois, Minnesota and Texas, according to data compiled by Bloomberg.

After New York Attorney General Andrew Cuomo and state securities regulators fined banks $572.5 million and ordered them to buy back auction-rate bonds, Citigroup said the $7.3 billion it bought declined in value by $500 million, or 7 percent. Merrill Lynch & Co., a unit of Charlotte, North Carolina-based Bank of America Corp., said its $12 billion of purchases were worth 3 percent less than face value, a decline of about $360 million.

The 2011 and 2022 New York bonds’ indentures, or documents that spell out the rights of issuers and investors, say “the state may from time to time purchase bonds” at the prevailing price and retire them.

There’s no prohibition on local governments buying their bonds in the open market, said Troy Kilpatrick, a managing director at Bank of New York Mellon in Pittsburgh, a trustee of auction-rate bonds. “You just don’t see a lot of it happen.”

100 Cents

Since New York withdrew notices in October of plans to replace some auction-rate debt, more of the bonds have traded at less than face value, according to data compiled by the Municipal Securities Rulemaking Board.

New York State Dormitory Authority bonds traded as low as 86 cents on the dollar, according to the MSRB. New York State Thruway Authority bonds changed hands on May 13 at 87 cents.

The state paid 100 cents on the dollar to redeem $1.83 million of the 2022 bonds on Feb. 15, according to an announcement of the transaction. An earlier purchase involving $10 million face value of debt was completed at 60 cents on the dollar, MSRB data show.

In another trade, $275,000 of taxable auction-rate bonds due 2011, changed hands at 90 cents on the dollar on Oct. 30, the MSRB data showed. The state redeemed $6.28 million of the bonds at 100 cents on March 15.

Budget director Laura Anglin said last month there were no plans for the state to bid for auction-rate bonds and take advantage of their low prices.

To contact the reporter on this story: Michael Quint in Albany, New York, at mquint@bloomberg.net.

Last Updated: May 22, 2009 00:00 EDT