Watchman Newsletter

The �Build America� Debt Bomb

The Wall Street Journal (Link) - Steven Malanga (November 22, 2010)

In a Rasmussen poll taken before the midterm election, half of the respondents said that members of Congress who supported the 2009 federal stimulus didn�t deserve to be re-elected. Many weren�t. Yet the lame-duck Congress might extend one of the key elements of that stimulus: �Build America Bonds� (BABs). States and municipalities have used these bonds to rack up some $160 billion in new debt over the last 19 months.

Build America Bonds were created to re-energize the municipal bond market, which contracted sharply in late 2008. Investors had become wary that the credit crunch would spread to municipals, as insurers who back state and local bonds got hurt in other markets and stopped insuring public debt. Facing declining tax revenue and growing deficits, some local governments suddenly couldn�t borrow.

The Obama administration responded with a new kind of taxable bond that offered a 35% federal subsidy on the interest rate. Washington designed the subsidy to appeal to investors such as pension funds and overseas buyers who don�t buy traditional municipal bonds because they can�t take advantage of their tax-free status. The federal subsidy allowed states and cities to offer these investors an attractive return. The catch: Congress authorized the program only through 2010, to allay concerns that BABs would become a permanent bailout.

States and cities jumped deeply into this new market. California alone has issued some $21 billion in BABs, mostly as a substitute for its general obligation debt to support everything from school construction to sewer projects. New Jersey has used up to $500 million to recapitalize its depleted transportation trust fund. Columbus, Ohio, issued $131 million in BABs to start construction of a downtown convention hotel. And in Dallas, Texas, when no private operator would finance a new convention hotel, the city went ahead with a government-subsidized hotel, courtesy of $388 million in BABs.

Now dozens of governments and other municipal issuers (like New York�s Metropolitan Transportation Authority and the University of California) have hired lobbyists to push Congress to extend BABs beyond this year. And in its 2011 budget, the Obama administration proposed making Build America Bonds permanent, with an interest-rate subsidy of 28%.

But the BAB program hasn�t been the unqualified success its advocates claim. While the original municipal bond crisis in late 2008 was attributed to the meltdown of other credit markets, it has since become clear that investors retreated from municipal debt as much because of the poor fiscal practices of many local governments. BABs have only contributed to the problem, increasing state and local debt even when the market has signaled that it considered some municipal borrowers overextended.

One sure signal has been the sharp rise in the cost for investors to insure against default. In June, the price of a contract protecting an investor from a default by Illinois on its bonds rose to a record high of $309,100 on $10 million of debt over five years, according to CMA Datavision. The national average for states is $190,000 per $10 million in debt. At that point, Illinois surpassed California as the worst credit risk among U.S. states.

A more telling signal was that, based on the cost of insurance contracts, CMA Datavision listed both states in June among the 10 biggest government default risks in the world. Illinois was at greater risk of default than Iraq. Yet thanks to the BAB subsidy, Illinois was still able to borrow some $300 million in bonds by offering a 7.1% interest rate.

Meanwhile, investors are realizing that states and localities face long-term costs in addition to their muni debt, especially retirement obligations. Joshua Rauh of Northwestern University and Robert Novy-Marx of the University of Rochester assess the 50 states� unfunded pension bill at $3 trillion, and they say that the municipal tab for pensions could reach $500 billion. That is on top of some $2.8 trillion in outstanding state and local borrowing, according to the Federal Reserve.

The Securities and Exchange Commission drew an explicit link between pension liabilities and municipal debt in August, when it charged New Jersey with fraud in its municipal bond offerings. The SEC cited the state for not revealing the true extent of its pension woes in its bond offerings�a clear indication the agency thinks growing pension debt may impede the ability of some states to meet other obligations.

The governments that have made the most use of BABs have been those with the greatest fiscal problems. The biggest issuer of BABs, California, has relied on an unprecedented number of gimmicks to balance its books in the last two years�such as temporarily increasing tax withholding rates and issuing IOUs to vendors.

New Jersey used a big chunk of its BAB funding to relieve the burden from past budget tricks. Over the years its legislature has diverted gas-tax money from its transportation trust fund, which is supposedly dedicated to public works, to paper over previous general account budget deficits. Now the state is borrowing with BABs to restock the trust fund, though servicing the interest on those bonds will haunt future budgets.

The Obama administration believes the BABs� direct federal subsidy is a more efficient way to raise money than traditional tax-free municipals. But when money that would otherwise go to private business flows into subsidized government activities, resources are misallocated.

This is no idle speculation: The financial press is full of stories of investment managers recommending BABs over corporate bonds with similar ratings, thanks to the advantage of federal subsidy. There is also a future bailout risk, given that the federal government might not allow a state or local government to default on a Build America Bond. None of this is what voters signed up for on Nov. 2. �

America ~ Economic Crisis ~ Obama