Will Build America Bonds save the States from default?

There has been a lot of talk recently about whether Build America Bonds (BABs) will be able save the state and local governments from possible default.   The BABs market recently broke a sales milestone of $100 billion, this done amazingly within in 13 months of the first bond issuance.

The Build America program was created in the American Recovery and Reinvestment Act of 2009.  Designed to spark investment in state and local government capital projects, the so called shovel ready projects, the program’s objective was to save or create 3.5 million jobs.  There are two types of BABs.  The first type, called Tax Credit bonds, are similar to traditional muni-bonds, in that the investor receives a 35% tax credit on the coupon payment.  The second type, called Direct Payment bonds, gives the issuing government a 35% rebate from the U.S. Treasury on the coupon interest.  To date, the vast majority of issuance has been in the Direct Payment arena.  It appears that the reason for the disproportionate issuance of the Direct Payment bonds has to do with the pool of potential buyers.    Because there is no preferred tax treatment for investors, interest rates are higher than those of traditional muni-bonds.  As a result, the pool of potential investors is increased as tax exempt or deferred accounts like pensions, retirement accounts, or foreign investors who wouldn’t reap the tax benefits of muni-bonds, are more likely to be purchasers.  Investors can now get a corporate bond type of return with a muni-bond type risk.    As a result, within the last year we have seen the launch of new EFT’s design to follow BABs.  Invesco’s PowerShares Build America Bond ETF (BAB) and Eaton Vance’s Build America Bond fund (EBABX) were created in November 2009, while the SPDR Nuveen Barclays Capital Build America Bond ETF (BABS) was recently created this May.   These funds will also push BABs out to smaller investors looking for diversification.

The Obama Administration is calling the program an enormous success, and included an extension to 2013 in the recently passed Jobs Bill this March.  While the program looks to be working, and bond issuers have saved roughly $12 billion in interest payments compared to what they would have paid in traditional muni-bonds, there has been growing opposition to the program.  Senator Chuck Grassley (R) calls the program a fleecing of the American taxpayer.  He purports that it merely robs from Main Street and rewards Wall Street in the form of high underwriting fees, and is advocating to have the program abolished.  With the Bank of America Build America Bond index returning 8.9% this year compared to a 2.75% index return in traditional municipal securities, it is no wonder that the market is growing so rapidly.  Is this a viable solution for the states and municipalities or, as Senator Grassley suggests, a fleecing of America?

The Wall St. fees are “surprisingly high” say Edward Prescott, a Nobel-prize winning economist.  Typical underwriting fees for BABs are $8.20 for every $1000 while traditional issues range between $5 and $6 per $1000.   “Of course state and local governments are big fans of Build America Bonds program—they get federal money that they don’t have to pay back,” Grassley said in a March 16 floor speech.  “And the large Wall Street investment banks love Build America Bonds—they’re getting richer off them,” as Goldman Sachs has received 10% of the total market issuance in the form of fees.  Grassley continues, “However, we all know there’s no such thing as a free lunch.  Federal taxpayers are footing the bill”.

The Congressional Budget Office estimated last year that BABs would cost the Treasury $4 Billion over 10 years, but, as usual with government projections of cost, the bonds have defied all expectations, and the program is now projected to add $30 billion to the deficit, a sevenfold increase.  With the program accelerating and the Obama Administration talking about make it permanent, although with a small caveat of reducing the subsidy to 28% to 30%, it appears that the taxpayer will be on the hook for an ever increasing amount.

Treasury Secretary Timothy Geithner said in January, that the bonds “were successful in helping to repair a severely damaged municipal finance market, making much needed credit available at lower borrowing costs for infrastructure projects that create jobs”.  He went on to say, “By making Build America Bonds a permanent and expanded financing tool for state and local governments, we’re investing in our country’s long term economic growth in a cost-effective way.”  The new proposal that the Administration has put forward expands the scope of the program to allow for the refinance of current debt, to cover short-term governmental operating costs, and to finance non-profit hospitals and universities.  This appears to include the financing of the huge level of unfunded state pension liabilities in many states like California and New Jersey.

On May 26, 2010 the State of Florida’s bond finance director, Ben Watkins, declared that the state will no longer participate in the issuance of Build America Bonds until such time that the government guarantees the subsidy on the program.  Watkins is worried that the Treasury can withhold all or part of the states subsidy, in Florida’s case some $600 million, if the issuer owes monies to the federal government through programs such as Medicaid, etc.   Florida is not the only state or municipality in this boat.  In February the IRS withheld subsidy payments to the City of Austin, Texas over payroll taxes, while the City of Los Angles was garnished some $28 million over an unspecified liability on $307.4 million of Airport bonds.  “It is a very real risk” that a subsidy payment may be garnished at some point over the life of the bonds, which is often about 30 years, Watkins said.

The BABs program is obviously accelerating, as leveraged states and municipalities look for ways to finance capital projects, budget shortfalls, and unfunded liabilities. It looks like BABs will help them temporarily extend durations and lower interest rates.  But will it save them?

In my view, while it helps in the short run, all BABs really do is delay the inevitable day of reckoning because it allows state and local governments to continue their spendthrift ways, burdening further the already over indebted American taxpayer (see Wow!! That’s A Lot of Debt! at TheStreet.com and www.ancorawest.wordpress.com).  Worse, BABs will make some state and local governments serfs of the federal authorities.  If they don’t tow the federal line for other federal programs like Medicare, Medicaid, the new health care law and other future and costly federal mandates, the Treasury can “garnish” the subsidies owed.  Given the deteriorated condition of state and local finances and the likelihood that such budgets will be squeezed for the indefinite future, the very independence of the states appear threatened.  Florida appears to have recognized this threat.

In the end, BABs 1) are too costly; once again, Wall Street appears to be benefitting, again at the expense of the American taxpayer; 2) make it too easy for state and local governments to continue their profligate ways which will continue to place heavier debt burdens on the taxpayers; and 3) threaten further to erode the constitutional concept that states are independent of the federal government.

Joshua Barone, Managing Partner

Robert Barone, Ph.D.

June 1, 2010