TAX CREDIT BONDS
National League of Cities
Finance, Administration and
Intergovernmental Relations
Steering Committee Meeting
Gadsden, Alabama
June 3, 2011
By: Frank D. McPhillips
fmcphillips@maynardcooper.com
(205) 254-1045
Overview of Presentation
Profile of Municipal Bond Market prior to
Financial Crisis.
Effect of Financial Crisis on Municipal Bond
Market.
Introduction of Tax Credit Bonds (a.k.a. Build
America Bonds) in ARRA.
What are Build America Bonds?
Legacy of Build America Bonds
Current Status of Proposed Legislation to Extend
BABs.
Profile of Municipal Bond Market – 2007 (Pre-Crisis)
States and local governments could borrow cheaply for
public works projects by paying tax-exempt interest rates.
Federal subsidy of muni bonds = forfeited tax revenues.
Over 70% of muni bond purchasers were mutual funds and
high net worth individuals.
Pension funds, tax-exempt organizations and foreign
investors were absent.
Total size of muni bond market = $2.8 trillion.
Profile of Municipal Bond Market – 2007 (Pre-Crisis)
Rating agencies (Moody’s, S&P and Fitch) were considered
reliable and trustworthy.
Seven bond insurance companies were rated AAA.
Large floating rate bond market was supported by letters of
credit issued by healthy banks.
Individual purchasers and money market funds relied on
AAA ratings and bond insurance to get comfortable with
their investment decisions.
Profile of Municipal Bond Market – 2007 (Pre-Crisis)
Inefficient Subsidy: State and local governments did not receive
100% benefit of federal subsidy.
Why not?
1)
2)
3)
4)
As borrowing demands grew, investor market was not large enough to
support it.
Therefore, in order to attract buyers from lower tax brackets, yield on
muni bonds had to increase relative to taxable yields. Higher yield
makes tax-exempt bonds competitive with yield on taxable bonds for
lower-income bracket bondholders.
Yield pushed up higher than a buyer in high-income bracket would
demand, resulting in windfall for high-income bracket individuals and
higher cost for states and local governments in form of higher interest
rates.
Tax experts estimate 20% of subsidy goes to high net worth buyers and
80% of subsidy goes to governmental issuer.
What Happened in 2008?
Demise of bond insurers – no more AAA-rated insurers.
Loss of confidence in rating agencies.
Commercial banks suffer severe financial stress, resulting
in letter of credit downgrades and put bonds.
$300 billion auction rate securities market explodes.
Result: safety net for municipal bonds evaporates.
By Q4 of 2008, monthly issuance fell to 68% of precrisis levels; cost of borrowing increased by more than
100%.
Municipal bond market enters deep freeze in Q4-2008
and Q1-2009.
Introduction of Tax Credit Bonds (a/k/a Build
America Bonds)
Passage of American Recovery and
Reinvestment Act – February 2009.
Proposal for Build America Bonds enjoyed
bipartisan support.
Purpose: to allow government issuers to access
larger market of taxable debt - $30 trillion
market instead of $2.8 trillion.
What are Build America Bonds?
Build America Bonds
1)
2)
3)
Taxable bonds with direct subsidy to government issuer of 35% of each
interest payment.
Subsidy treated exactly like tax refund.
Eligibility for BABs mirror eligibility for tax-exempt status of
governmental bonds for capital projects.
–
–
–
4)
Private activity bond tests apply.
Arbitrage rules apply.
Limitation in advance refundings apply.
No volume cap.
Recovery Zone Economic Development Bonds
1)
2)
3)
Species of Build America Bonds with 45% direct subsidy.
Intended to “turbo-charge” recovery by jumpstarting capital projects.
Limited volume cap.
Tax Credit Bonds Without Direct Subsidy
1)
Variation allowed under ARRA but never used by any issuer.
Legacy of Build America Bonds – Huge Success
Over 50% of municipal bonds in December 2010
were BABs - $181 billion issued from April,
2009 through December, 2010.
BABs issuers in all 50 states saved, on average,
84 basis points on interest costs on 30 year
bonds.
BABs issuers saved $20 billion in present value
borrowing costs compared to tax-exempt bonds,
which was significantly greater than net cost to
federal government.
Legacy of Build America Bonds
BABs took pressure off tax-exempt market, as
lower volume could be supported by muni
investors.
More beneficial for states and local government
issuers – 100% of federal subsidy benefitted
issuer.
Legacy of Build America Bonds
Wall Street Journal: (February 18, 2010) “A
Stimulus Plan Success Story”:
“The experiment worked. It helped revive the
muni-bond market, keeping local construction
projects going . . . Sometimes, the system
works.”
Legacy of Build America Bonds
Time Magazine: (November 17, 2009) “A
Stimulus Success: Build America Bonds Are
Working”:
“When Congress wrote the Build America Bond
program into February’s $787 billion economicstimulus bill, many predicted a flop. Nine
months later, the municipal bond program, which
provides a federal subsidy to help states and
other local governments raise funds, looks to be
one of the economic recovery effort’s biggest
successes.”
Current Status of Build America Bond Legislation
Congress allowed BABs to expire on December
31, 2010.
President Obama’s 2012 budget proposes
making BABs permanent at reduced 28%
subsidy rate; expands eligible uses to cover
certain refundings, short-term working capital
and non-profit entities such as hospitals.
May 17, 2011 Senate Finance Committee hearing
– CBO testified in support of BABs, stating they
are “more cost-effective” and “transparent”
compared to tax-exempt bonds.
Proposal – Using BABs to promote disaster recovery
Bring back BABs for use in financing disaster recovery plans of
states and local governments.
Three examples of disaster relief legislation – New York Liberty
Zone Act, post-9/11, post-Katrina, Gulf Opportunity zone Act and
Heartland Disaster Relief Act – contain incentives which benefit
private sector but provide very limited assistance to governments
faced with task of rebuilding infrastructure.
Unlike previous disasters, Alabama tornadoes struck just as local
governments are still reeling from economic disaster of last several
years.
BABs have role to play in reducing cost of recovery for communities
devastated by natural disasters.
Cost of BABs for disaster relief can be calibrated by using (i) volume
caps, (ii) lower subsidy levels and (iii) geographical limitations.
Proposals to Eliminate Tax-Exempt Bonds
Deficit Commission Report proposes elimination of tax-exempt
bonds without any substitute in the name of deficit reduction.
Sen. Ron Wyden (D-Ore.) proposes elimination of tax-exempt
bonds, replacing them with tax credit bonds (not direct payment
variety).
Both of these proposals would dramatically increase borrowing costs
of local governments.
Although ARRA permitted issuers to choose between direct payment
bonds and tax credit bonds where holders receive tax credit, none of
the latter variety ever issued.
There is no existing market for pure tax credit bonds, so no
efficiencies would be realized.
New market would eventually develop consisting of subset of high
net worth individuals which would be even thinner than existing taxexempt market.
Bank-Qualified Bonds
Effect of BQ status: allows banks to deduct 80% of interest expense
allocated to carrying BQ debt. Incentivizes banks to purchase BQ
debt.
Prior to 1986 – all governmental issues were bank-qualified;
therefore, banks were major market participants.
1986 Tax Act – BQ debt limited to cases where issuer and its
subordinate entities issue less than $10 million in calendar year.
ARRA raised $10 million cap to $30 million, greatly increasing
willingness of banks to make loans to smaller issuers.
Expiration of ARRA caused cap to return to $10 million.
Municipal Bond Market Support Act of 2011 would restore $30
million cap – Sens. Bingaman, Cardin, Kerry, Crapo, Grassley and
Snowe are sponsors.
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