Obama proposes Fed to support muni market

NEW YORK (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.

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.