UPDATE 1-US Treasury should backstop ARS muni debt -group

NEW YORK Oct 29 (Reuters) - The U.S. Treasury should backstop auction rate debt sold by U.S. states, cities, hospitals, turnpikes and other authorities by adding it to the government's $700 billion bank bailout, two industry associations said on Wednesday.

Giving muni issuers that still hold $200 billion of auction rate debt a so-called liquidity facility from the U.S. government would "free" them from high penalty interest rates triggered when auctions of this debt fail, the Regional Bond Dealers Association and Education Finance Council said in a joint letter to the Treasury

The proposal would unlock markets now frozen by the many banks unwilling to tie up their balance sheets by selling letters of credit -- and the steep fees they now charge, according to the two groups.

The Washington, D.C.-based Education Finance Council serves state and public nonprofit student loan finance agencies. The Alexandria, Virginia-based Regional Bond Dealers Association represents regional securities firms.

The January collapse of the $430 billion muni auction rate market hit many issuers with sky high interest rates, while students were unable to get loans.

State attorneys general wrested hundreds of millions of dollars of settlements from banks that sold the debt to investors, who then could not sell the debt when they needed to.

Though other U.S. companies, including carmakers, are also seeking federal aid, the muni plan would not imperil the Treasury because the credits are often high-quality, according to the bond dealers group.

The two groups also predicted the Treasury likely would not have to buy "a large volume of securities." If it did have to buy assets, it would profit because the penalty rates it would get would top the Treasury's cost of funds, the groups said.

A Treasury spokesman had no immediate comment on the plan, which calls for the muni issuers to recast their auction rate securities as variable rate demand notes.

On Monday, David Nason, assistant Treasury secretary, said banks were first in line for aid for the sake of "financial stability and providing credit." But he said the agency would listen to requests from other industries.

The Treasury would get a fee of about 0.45 to 0.55 percent of the amount guaranteed. The program could end in three years if, for example, a review found private backstops, such as bank letters of credit, were plentiful.

The U.S. government has already had to make good on its implicit backing of mortgage lenders Fannie Mae FNM.N and Freddie Mac FRE.N. But the groups predicted that a facility for the muni industry would not be drawn on "to a significant extent, because its mere existence would likely provide confidence to investors and restore normalcy to the market for the affected products."

Many student loan auction rate securities are already "indirectly guaranteed" by the U.S. government, which backstopped the underlying student loans.

Money market funds would be able to buy the new variable rate demand notes the muni issuers would sell, which also would improve demand, the groups said.

Only variable rate demand notes offer the protection of liquidity facilities. Auction rate paper lacks this backstop, which is why it created problems for holders who tried to sell it en masse because they feared bond insurers would lose the top ratings their business demands.

Many muni issuers transformed their auction-rate debt into variable rate demand notes, only to see this $400 billion freeze a short time later, when sellers, again fearing bond insurers would be downgraded, flooded dealers. (Additional reporting by Patrick Rucker in Washington, D.C.; editing by Leslie Adler)