CDOs are no longer a one-off phenomenon in the municipal market.

While some doubt that CDOs will ever become common in the municipal market, dealers have been quietly tinkering with structures to see whether they can find one that works.

A group led by UBS a few months ago began marketing just the second such tax-exempt deal - a $400 million transaction set to close next month, according to a presale report published by Derivative Fitch. The deal is being called Republic Funding Trust I.

To date, only one such deal has been created from municipal bonds. Last fall, a group led by Merrill Lynch marketed what has been considered the first municipal CDO, a deal called Non-Profit Preferred Funding Trust I. It was designed to be about $400 million in par volume and had a 250-day ramp-up period, according to rating agency reports issued at the time.

Republic Funding Trust I has a 180-day ramp-up period, which reflects the different strategy that UBS and its partners have used to gather the underlying bonds for their deal.

While the group that developed the Non-Profit trust originated much of the underlying debt themselves, UBS's group has opted simply to buy bonds in the market, said Alla Zaydman, senior director at Derivative Fitch. This means that UBS had less work to do in putting its trust together.

"They're buying on the market," she said. "The bonds are mostly publicly rated, and they have marks and they trade and all that other good stuff."

By closing, the group will have purchased about 70% of the deal's underlying bonds, according to Fitch's report. Merrill's deal aimed to purchase just 50% of its underlying credits before closing.

Along with UBS, Morgan Keegan is listed in the Fitch report as an underwriter on the Republic trust. Patrick Morrissey and Gary Binkiewicz of FSI Capital will help manage the portfolio of underlying credits, and U.S. Bank will be the trustee.

UBS and FSI Capital would not comment for this story, saying they could not discuss the deal until it prices.

The Republic trust will include 75 to 100 tax-exempt bonds from several different states and sectors, according to Fitch.

As in the Non-Profit trust, healthcare and education will be the most heavily represented sectors in the Republic deal. Republic is also expected to include debt from the cultural, research, housing, tobacco settlement, industrial development, tax increment, and utility revenue bond sectors.

No single obligor will account for more than 3% of the pool, and about 20% of the pool will be rated BBB-' or better, according to Fitch. About 79% of the trust's certificates will be ratcheted up to AAA'.

When Fitch published its presale report for the Republic trust in early May, the underlying pool included bonds from 20 different states, the rating agency said.

While this is only the second muni CDO, analysts from Moody's Investors Service said they routinely receive calls from people considering potential new structures for them. Callers have proposed diverse and sector specific trusts - even some ideas based on tobacco bonds.

Several barriers have kept CDO-style deals to a minimum in the municipal market. For example, any transaction that involves creating a "debt obligation" using bonds as "collateral" could be ineligible for the tax-exemption that draws most investors to muni bonds, explained Sidley Austin partner Max Von Hollweg at a conference earlier this month. Von Hollweg worked as special counsel in the Non-Profit trust.

Beyond the basics of taxability, sheer competition for high-yield muni bonds has also made it hard for dealers to piece together CDO-style deals, buy-side sources said.

"It's very difficult to aggregate a quality portfolio of high-yield names with strong covenants," said Ross Berger, head of credit for the proprietary tax-exempt portfolio at Wells Fargo Bank.

Some of the investors that dealers would count on to invest in their new STEPs are the same funds competing with them for the underlying bonds, said another investor familiar with UBS's deal. Part of marketing CDO-style deals in the muni market is overcoming this competitive friction.

"Those guys, when they get ramped up, can be a real competitive force," one of the investors said. "They will directly compete with high-yield mutual funds, and closed-end funds, and life portfolios and all kinds of stuff. So, one of the natural headwinds that they're going to face is perceived competition."

He added, though, that investors likely will be "pretty comfortable" with the models of such deals, as long as they conform to the models of CDOs used in other fixed-income markets.

"If these guys are successful, then another marketing machine like this CDO manager is going to come out and try to roll out another one - and another one and another one," he said.

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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