UPDATE 2-Obama proposes Fed to support muni market

(Adds comments from Nevada treasurer)

NEW YORK, Jan 8 (Reuters) - President-elect Barack Obama proposed on Thursday having the U.S. Federal Reserve buy municipal bonds to cut lofty borrowing costs for cash-strapped cities and states.

The facility would be similar to a backstop program that helped thaw the commercial paper market, Obama said in an outline of his plan to revitalize the economy posted on his website.

“This new facility should be designed to protect taxpayer resources while ensuring that state and local governments can continue to provide vital services to their residents,” he said.

The Regional Bond Dealers Association said the proposal recognizes the weakness in the municipal bond market brought about by the credit crisis and recession, and can help states and localities finance their operations.

For the last year, the credit crisis has shaken the muni market, chipping away at investor confidence and hurting issuers’ ability to raise needed funds.

Investors have fled tax-free munis and sent yields to historic highs following the freeze of the auction-rate market, downgrades of muni insurers and the loss of huge liquidity providers such as Bear Stearns & Co. For more, see [ID:nN05363840].

In addition, the sputtering economy has cut tax revenues for states and cities. As many as 41 U.S. states and the District of Columbia are grappling with budget deficits in the current fiscal year, according to the Center on Budget and Policy Priorities, a nonpartisan think-tank.

California, for example, faces a $42 billion deficit through fiscal 2010, and is warning that it may run out of cash by February and be forced to issue IOUs in lieu of salaries to public sector workers.

“Small businesses and state and local governments are having serious difficulty obtaining necessary financing from debt markets,” Obama said.

He proposed basing the municipal bond facility on the Fed program to buy commercial paper. The Fed’s substantial purchases of commercial paper have almost single-handedly propped up the market for short-term corporate borrowing.

Investors welcomed the proposal as a first step toward supporting the market. It signals a federal willingness to consider aiding local governments and is helping revive investor confidence in municipals, according to Dominick Mondi, senior managing director at Mesirow Financial Inc in Chicago.

“It just shows that the Fed and the Treasury are not going to ignore it,” Mondi said. “There are budget deficits they are facing and they need to be able to finance. If the states and locals need a bridge, I personally think that’s marvelous.”

Tom Dresslar, a spokesman for California State Treasurer Bill Lockyer, agreed.

“It’s heartening that we’re starting to see a recognition on the part of the federal government, particularly the president-elect, that municipal government issuers have not been operating in some parallel economy and have been hurt along with taxpayers,” Dresslar said.

Outgoing Washington State Treasurer Mike Murphy said a federal backstop is an “interesting” idea although he had some concerns. “I’m not real clear who they would be guaranteeing. ... If the Feds were to get involved in this business then would there be another layer of regulation?” he asked.

Nevada State Treasurer Kate Marshall said, “Liquidity in the market is still an issue and anything he can do to loosen that joint is a good thing ... But I think there are some questions still as to how it would work.”

States have repeatedly called for government aid but have so far been left out of the bailouts that benefited the financial and auto industries.

Lawmakers in the U.S. House of Representatives on Wednesday pledged that they would include assistance for state and local government in the economic stimulus bill planned by the new administration. [ID:nN07437444]. (Reporting by Ciara Linnane; Additional reporting by Michael Connor in Miami, Lisa Lambert in Washington and Jim Christie in San Francisco; Editing by Leslie Adler)