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Obama’s Economic Stimulus Plan Causing Controversy with Build America Bonds

Obama’s Economic Stimulus Plan Causing Controversy with Build America Bonds

They are supposed to help states and cities that are short of cash build roads, schools and bridges.

But Build America Bonds, part of President Obama’s economic stimulus plan, are also building something else: controversy. The federal government pays 35 percent of the interest costs on the bonds, a huge potential saving.

States and cities have embraced these taxable bonds to borrow money at what they assume are favorable interest rates. But questions about this multibillion-dollar program are piling up.

For one, Wall Street banks are charging larger commissions for selling Build America Bonds than they do for normal municipal bonds, increasing the costs to the states and cities.

For another, the new bonds may be priced too cheaply, enabling quick-footed investors to turn a fast profit as the prices climb, but raising interest costs for taxpayers.

Those imbalances have caught the eye of the Internal Revenue Service, which is asking municipalities whether the bonds are being priced and sold correctly.

Alarmed by the uncertainty, Florida, which has sold more than $1.6 billion of Build America Bonds, has retreated from the market. As if all this were not enough, Wall Street banks - which have pocketed hundreds of millions of dollars in fees from the program - are now releasing research reports warning that states’ financial woes may make the bonds less attractive.

Some banks are even telling investors how to bet against Build America Bonds.

The Obama administration wants to make the program permanent, but Senate Republicans introduced a bill that would let it expire as scheduled at the end of this year.

The program was created in the wake of the financial crisis to expand the traditional tax-exempt municipal bond market and attract a broader audience of investors.

The market has exploded in size:

More than $109 billion in Build America Bonds has been sold, according to Thomson Reuters, a news and financial data company. “We’re quite thrilled with the program,” said James L. McIntire, the treasurer of Washington State, which sold $1.1 billion of the bonds a few weeks ago.

He estimated that the bonds would save the state $155 million in interest payments. Another clear winner has been Wall Street.

Banks have collected nearly $700 million in fees for helping to issue the bonds – a number that is low because fees are not reported in a third of the transactions.

For banks, Build America Bonds are more lucrative than traditional municipal bonds.

Weighted by size, municipal issuers paid $6.55 per $1,000 of Build America Bond sold in June, compared with $6.08 for traditional municipal bonds. Bankers argue that the fees are fair because Build America Bonds are new.

Over time, they say, the fees have fallen.

Even as it sells the bonds, however, Wall Street is thinking about how to play both sides of the new market. In an April 29 report to clients, a Citigroup analyst wrote that investors who are tuned in to the “widely known municipal budget struggle” can now use derivatives and other financial mechanisms to sell short Build America Bonds.

The I.R.S., which is involved with disbursing the federal subsidies under the program, is taking a closer look at Build America Bonds, too. It is asking states for information on how the bonds were priced after some traded at significantly higher levels shortly after being issued. That could cause municipalities to pay higher yields than necessary.

“When you see bonds sold almost immediately at a different price, that raises a question. It may be fine, or it may not be fine,” said Steven Miller, deputy commissioner of the I.R.S.
The I.R.S. scrutiny also raised concerns among some state officials that subsidy payments could be withheld if it were discovered that states owed the government back taxes or money for other federal programs.

In March, officials in Austin, Tex., received a letter from the I.R.S. saying the city would not get a $670,000 bond subsidy payment because it owed at least that much in federal tax penalties.

“We were surprised,” said Art Alfaro, the treasurer of Austin.

“We knew the risk was there, but there’s just no way for a big organization like us — we have 28 departments - to know if one department owes $10.” The city is contesting the penalty.

More recently, Florida decided to stop selling Build America Bonds given the potential financial implications for the state. “We had been enthusiastic users of the program,” said Ben Watkins, the director of bond finance for Florida.

The bonds will save Florida an estimated $250 million in interest over the life of the debt, he said. But Florida officials say they now believe that the risk is too great that the state might be denied the subsidies associated with Build America Bonds. “States are big, complicated entities,” Mr. Watkins said. “There’s no way for me to effectively manage that risk.”

While most states have embraced the program, two, California and New York, account for a third of the money raised through it, said Senator Charles E. Grassley, a Republican from Iowa and a critic of Build America Bonds. “The program might be better named the Build California and New York Bonds Program,” Mr. Grassley said.

A handful of states and municipalities, less than 2 percent, have been denied federal subsidies because of money they owed.

The Treasury Department said in a statement that Build America Bonds remained popular among states and cities, despite concerns over whether these borrowers might one day lose their subsidies. “Local governments in nearly every state have saved billions of dollars by using Build America Bonds to finance critical capital projects that are rebuilding infrastructure and creating jobs,” the statement said.

“It’s unfortunate that a state would choose to forgo the opportunity to save its taxpayers millions of dollars simply to avoid paying overdue taxes to the federal government.”

According to the Treasury, the fees on Build America Bonds “have been small relative to the significant savings on interest costs.”

Still, some analysts are asking whether the program is needed now that the worst of the financial crisis is over, according to this report from the New York Times.
Interest rates, including those that states and cities pay on traditional municipal bonds, are at their lowest levels in decades, said Thomas Doe, chief executive of research firm Municipal Market Advisors, a research company.

But taxpayers will be paying the bill for the Build America Bonds program for years, he added. “What’s clear is that the federal government, over the life of the Build America Bond issues, will be writing checks in excess of $50 billion to cover the interest,” he said.

And while this may sound like a lot of money – given the immediate crisis states and municipalities currently confront, and the fact that sum will be spread over a large number of both years and governments – it seems like a paltry amount indeed.

David Caploe PhD
Chief Political Economist
Economy Watch




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