As you have probably learned over the last 18 months since the passage of the Recovery Act, Congress approved the issuance of taxable municipal bonds. If the municipal issuer complies with the same rules as would be applicable to its tax exempt bonds, with some additional and tighter restrictions, the issuer can elect to have the United States Treasury pay the issuer an amount equal to 35% of the interest paid on the taxable bonds. As a result of this interest subsidy, a municipal entity can borrower at a net interest cost that is lower than if it issued traditional tax exempt bonds.

 

These taxable bonds with the interest subsidy are called Build America Bonds (or "BABs" according to the market). Since the passage of the Recovery Act, billions of dollars worth of Build America Bonds have been issued.  The authorization to issue BABs expires at the end of 2010. The House of Representatives in Washington has attempted to pass legislation to continue the BABs into the future but with a reduced interest subsidy rate. Even at the reduced rate, the result would be a lower net interest cost for municipal issuers. The Senate has rejected the extension legislation, as recently as the next to last week in July when it stripped such language from the bill which extended unemployment insurance benefits.

 

If I were King, I would make the BAB program permanent. However, I would not provide an interest subsidy that exceeds the rate utilized by the market to determine the rate on tax exempt bonds. In other words, there would be no difference between the gross interest cost on tax exempt bonds and the net interest cost on the taxable BABs.  

 

I would do this for three reasons:

 

1. BABs have substantially expanded the market for municipal bonds to the benefit of local governmental issuers.

2. Structuring the program this way will allow the continued issuance of BABs at no additional cost to the federal government or local governments.

3. Unprecedented economic circumstances facing local governments have greatly diminished their willingness to undertake extraordinary economic stimulus projects such as those BABs were intended to drive.

 

As to reason number one, by allowing local governments to access the taxable bond market, BABs have substantially increased the field of potential buyers. If one believes in the law of supply and demand, more demand from buyers means lower rates are needed to sell the bonds. For example, in July we served as underwriters' counsel on two BABs financings by the State of Illinois that totaled $1.2 Billion. We know for a fact that with the second issue, which was a negotiated sale, over 17% of the bonds were purchased by buyers who live outside the United States and do not pay US taxes. Those buyers would never have considered buying Illinois bonds if they had been issued as tax exempt. As a result of this extra demand, the bonds were re-priced at lower rates before the purchase contract was executed.  It is estimated that the State saved over 50 basis points in the gross interest rate as a result of this foreign demand. With the federal subsidy, the net interest cost to the State was substantially lower than with tax exempt bonds. On $900 million over 25 years, that's a lot of money.

 

On the tax exempt side, less supply from issuers means lower rates are needed to satisfy the same demand. As more bonds have been issued as taxable, a large demand for tax exempt bonds has built up. That demand has resulted in the spread between tax exempt and taxable rates increasing with tax exempt rates staying at near record low levels. If issuers had the choice between tax exempt and taxable deals at no difference in the net rates, they could choose which way to proceed at the time of sale thereby taking advantage of the differences in the markets based upon supply and demand at that time.

 

As to reason number two, by reducing the interest subsidy, there would be no impact on the federal budget.  If, for example, a 25% tax rate is the rate the market assumes in determining the applicable tax exempt rate, the federal government is already subsidizing local government borrowing by the amount of interest that escapes federal income taxation. And there is no limitation on how much debt local governments can issue. If the interest subsidy on BABs is set at the same 25%, there would be no additional cost to the federal government. Whether it gives the local government 25% or does not tax bondholders on the interest assuming a 25% tax rate, allowing BABs is a wash to Washington. In fact, it might even result in a gain to Washington because there are buyers of tax exempt bonds that are taxed at a rate higher than 25%. Those bondholders reap a windfall when the interest rate is established based upon a 25% tax rate. To local governments, it would also be a wash compared to tax exempt rates.

 

As to reason number three, I have observed no projects being undertaken and financed with BABs that would not have been undertaken and financed with tax exempt bonds if BABs did not exist. The BABs have initially been used to reduce the cost of borrowing for the issuer and its taxpayers or ratepayers. If the economic and political circumstances that have driven local and state government to be conservative in their initiation of extraordinary stimulus projects continue to dominate the concerns of voters and politicians, BABs may not stimulate the economy sufficiently for the federal government to over-subsidize local governments.