It remains one of the most popular ideas in the White House’s economic stimulus law: Helping states and localities weather the credit crisis by selling a new breed of taxpayer-subsidized municipal debt to investors. School districts, transit agencies and water authorities in more than 40 states have won by lowering their borrowing costs. Lawmakers and the Obama administration have won by touting unprecedented demand for securities with the feel-good name Build America Bonds (BABs).
[Economy1] But even as the program gains new converts and sails toward a three-year extension, approved by the House last week, hiccups have emerged to little notice outside the financial press. Some of those questions stem from wins scored off the bonds’ rapid rise by Wall Street players, including banks that commanded higher fees to underwrite BABs and traders who made quick profits selling them in the secondary market. Another sticking point arose earlier this month, when Florida suspended its BAB sales amid concerns that the Internal Revenue Service could withhold its promised subsidy for the bonds from states with outstanding Medicare or Medicaid obligations.
“We’ve always been concerned about the federal government creating a taxable bond option, or BABs, and using it to achieve other objectives … in terms of withholding payments that may be due a state or local government,” said Government Finance Officers Association (GFOA) executive director Jeffrey Esser, whose group represents municipal financiers. “We’re also concerned that, given the bad fiscal situation the federal government is in, they’ll make promises to provide these subsidies, [then later] be forced to cut back.”
BABs are structured to offer local issuers a federal repayment for 35 percent of the interest on their debt, which can also be taken by investors in the form of tax credits. The Congressional Budget Office estimated last year that BABs would cost the Treasury $4 billion over 10 years, but the bonds have defied all expectations — with nearly $80 billion worth flying out the door since the stimulus passed, the program is now projected to add $30 billion to the deficit, a more than sevenfold increase.
State and local bond issuers interviewed by TWI agreed that such popularity is an indisputably good thing. Yet several others emphasized that climbing aboard the BAB juggernaut requires vigilance and awareness of the risks involved, of which three in particular loom large.
Higher Underwriting Profits
When Goldman Sachs placed an ad in Politico last month trumpeting its status as a leading underwriter of BABs, Sen. Chuck Grassley (R-Iowa) went on the offensive. After firing off a letter to the bailed-out bank’s CEO, Grassley continued to hammer the program for allowing big banks to claim higher fees for negotiating BAB deals than they would for sales of traditional, tax-exempt municipal bonds.
“Of course state and local governments are big fans of the 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 of them. However, we all know there’s no such thing as a free lunch. Federal taxpayers are footing the bill.”
The full story, as relayed by many public works officials who sell BABs, is more complicated. They say the higher fees were common during the first few months of the program but have since normalized as the bonds become more of a fixture in the market.
What’s more, the pool of potential BAB buyers is much broader and larger than that for tax-exempt bonds. Foreign investors have embraced BABs, increasing their ownership of American municipal debt by 50 percent during the program’s first year, and BAB sales often put corporate bond traders in competition with municipal bond traders.
“You’re dealing with a brand-new product and new investors; when the first few [BAB] issues are done, you’re kind of guessing,” Bay Area Toll Authority chief financial officer Brian Mayhew, whose agency issued $1.3 billion in BABs last fall. “Is it a corporate transaction selling a muni[cipal] venture, or is it a muni transaction selling to the corporate world?”
Underwriters of BABs have so far commanded fees comparable to those associated with sales of high-grade corporate bonds. But Grassley has not abandoned the issue, playing up a Wall Street Journal story this month that pegged Goldman as the number-one BAB underwriter.
The debate over big banks wringing money from taxpayers and mom-and-pop local bond issuers flared anew on Friday, when a Justice Department list of co-conspirators in a municipal bond-rigging case was “inadvertently” disclosed in court filings. Lehman Brothers, J.P. Morgan and Bank of America were among the banks complicit in the scheme. BABs were not involved in the case, which centers on a different type of investment deal.
Leaving “Money on the Table”
About a month after the first BAB sales, Bloomberg reported that the program’s five largest bond issues had seen yields fall sharply after their initial sales, suggesting that local governments could have set their interest rates even lower — thus generating more money for public works projects — and still sold plenty of bonds. A second Bloomberg analysis found that New York City’s Metropolitan Transportation Authority could have held onto $9 million, enough to buy eight subway cars, by lowering its BAB yield just 0.1 percent.
Bonds, like stocks, change in price every day, but yields generally serve as a measure of their rate of return. So when BAB sales are being negotiated, “you have to push real hard,” explained Gary Breaux, director of finance at San Francisco’s East Bay Municipal Utility District. “It’s kind of a cat-and-mouse game. Investors are trying to get as high a yield as they can.”
About 70 percent of BAB sales during the program’s first year were negotiated, meaning that banks such as Goldman worked with municipal issuers to set the interest rate most agreeable to all sides. Esser’s group, the GFOA, recently advised its members to seek out competitive sales instead, forcing aspiring underwriters to vie for their business.
“Wall Street is very good at convincing state and local governments that every deal they’re doing is so unique and so unusual that it has to be negotiated to be successful, and we don’t agree with that,” Esser said.
Several BAB issuers acknowledged in interviews that they were concerned about selling debt at interest rates too favorable to investors. “It’s a problem you have to be mindful about,” said Dallas Area Rapid Transit chief financial officer David Leininger, who sold $750 million in BABs to pay for an expansion of local light rail.
“Nobody likes to leave money on the table,” agreed University of California chief financial officer Peter Taylor, who sold two rounds of BABs last year. Still, both Leininger and Taylor said they were satisfied with the pricing of their BABs, and Taylor called the program “a big home run.”
The IRS recently opened its own inquiry into the issue, sending out a “compliance check” that asks issuers how many saw BABs rise in price before the debt was delivered — a sign that investors were “flipping” the bonds by unloading them in the secondary market for a quick profit.
Both BAB investors and issuers said that pricing of the bonds has evened out in recent months as the program becomes more popular, offering an explanation similar to that for the higher-than-normal underwriting fees.
“That may have been an issue early on,” Regional Bond Dealers Association CEO Mike Nicholas said. “But the market has matured, so I don’t think that’s a consistent problem.”
The final bump in the road for BABs came when Florida announced its temporary exit from the market after an IRS conference call that left Ben Watkins, the state’s bond finance director, uncertain about whether he should rely on the federal government’s promise of subsidies.
Watkins said the Treasury Department had tried to reassure him about BABs’ long-term viability, noting that the program was designed as a tax refund so state and local governments would not be subject to the whims of congressional appropriators. “So, the only way you couldn’t get paid is if Congress changes the law,” Watkins said. “Not a slam dunk in and of itself.”
The House has passed legislation extending BABs until 2013, while gradually lowering their federal subsidy to 30 percent of interest. The Senate is expected to make a similar push before the stimulus law’s BAB provision expires at the end of this year, though criticism from Grassley and Senate Minority Whip Jon Kyl (R-Ariz.) could slow the process in the upper chamber.
Watkins, however, is looking for more than a reauthorization of the program. “I can’t permanently increase my exposure to the federal government without getting some clarity on” whether the bonds’ taxpayer subsidy to states could be garnished by Washington, he said.
The IRS did not return a request for comment on Watkins’ concerns and whether BAB interest payments were subject to withholding.
Meanwhile, the Build America concept continues to win political praise and practical kudos. President Obama called the program “one of the most successful” stimulus efforts, proposing to make BABs permanent in his most recent budget. And local issuers of the bonds like the prospect of raising more money cheaply to pave roads, build schools and pump water.
“We’re still learning” how to make the most of the corporate bond world, said Mayhew, of the Bay Area toll agency. “We’re getting better at understanding. But we’re not there yet.”