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Build America Bonds face an uncertain future

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Build America Bonds, a new type of municipal bond program launched last year as a federal stimulus initiative, could evolve into an ongoing alternative financing tool for local government projects. Then again, it could just as easily disappear by Jan. 1.

In less than two years, the state of Iowa and about three dozen cities and counties have collectively borrowed more than $500 million through the Build America Bonds program. Whether the program created during the Great Recession will endure as an alternative capital financing source – and a popular investment vehicle for Iowa banks – remains uncertain, however.

“We really haven’t done many (Build America Bond) deals this year,” said Bob Josten, a bond attorney with Dorsey & Whitney LLP in Des Moines. “We did a fair number last year as things were getting cranked up. And then, of course, people began to hear about the potential drawbacks.”

Unless it’s extended by Congress, the authorization for Build America Bonds is set to expire on Dec. 31. The program has drawn the scrutiny of the Internal Revenue Service, which is currently examining several large issues by cities, among them Chicago and San Antonio. Additionally, Iowa Sen. Chuck Grassley has called for an investigation into the fees charged by large investment banks for the bonds.

Taxable borrowing

Nationwide, more than $150 billion in Build America Bonds have been issued since the program’s inception, according to the latest monthly update by the Treasury Department.

In Iowa, there have been 34 Build America Bond issues totaling $531 million as of Oct. 31, according to the Treasury report. The cities of Des Moines, Altoona and Urbandale are among Greater Des Moines municipalities that have issued Build America Bonds in the past two years.

The Iowa treasurer’s office has been the single-largest issuer in the state. In July 2009, the state issued $221 million in Build America Bonds to fund more than one-third of the I-JOBS capital improvements and job growth program.

Established in April 2009 as part of the American Recovery and Reinvestment Act (ARRA), the Build America Bonds program was meant to provide state and local governments with an alternative to issuing traditional tax-exempt municipal bonds. By issuing the bonds, the governmental entity borrows money on a taxable basis to fund capital projects, and receives a direct subsidy from the federal government of 35 percent of the interest cost.

Though Build America Bonds now make up approximately 21 percent of the U.S. municipal bond market, the percentage is likely far smaller in Iowa because the majority of those bonds have been issued by the largest U.S. cities. Even if smaller cities in Iowa can access Build America Bonds, they’re much less likely to opt for them, said John Danos, a Dorsey & Whitney bond attorney.

“There’s almost a natural default setting of ‘We’re probably doing tax-exempt bonds unless the financial adviser or underwriter shows there are clear savings if we go the other route,’” he said.

Bond deals can be negotiated or put out for bid through public sales.

“On the deals we’re working on with financial advisers, when they do their public sales, they’re actually offering the deal as either tax-exempt bonds or Build America Bonds,” Danos said. “Then they take bids, and figure out which option presents us with the best financial picture for the governmental entity. In the truest sense, it’s letting the market decide.”

Build America Bonds issued in Iowa have proved to be popular with investors, particularly Iowa banks, that are seeking safe investments paying higher yields than tax-exempt issues.

Iowa-issued Build American Bonds have a very strong appeal because of their security, said Greg Tucker, a senior vice president with Ruan Securities, a division of D.A. Davidson & Co.

“In the last quarter of ’08, the market hit the wall,” he said. “A lot of the big companies we thought were as solid as a rock all of a sudden didn’t pay out. You do a Build America Bond on a city or municipality in Iowa, that’s about as secure as you can get. I deal mostly with institutions, and there is a huge demand for Build America Bonds.”

Tucker said that typically, 75 to 80 percent of municipal bonds in the state are purchased by Iowa-based institutional investors, “and the majority of the Build America Bonds we’re selling go to Iowa banks. They’re very supportive of their own state.”

The average Build America Bond investment per bank has been relatively small, $250,000 to $500,000, but that reflects the conservative nature of the banks as well as the small size of the issues, he said.

Tucker said that he doesn’t expect the Build America Bonds program will be extended into 2011, however, because the direct subsidies appear to be costing taxpayers more than tax-exempt issues.

Split issues

From the issuers’ perspective, Build America Bonds make the most financial sense for capital projects requiring longer maturities, said Chip Schultz, senior vice president and manager of public finance for Ruan Securities in Des Moines.

“The interest benefit tends to be more beneficial in the 15- to 20-year range as opposed to a shorter maturity range,” he said. “We may do a split bond issue, where we have tax-exempt bonds for the shorter maturities and Build America Bonds for the longer maturities.”

The structure of the $600 million I-JOBS bond issue was driven by those same economics, said Stefanie Devin, a deputy treasurer with the Iowa treasurer’s office. Of the total borrowed, $380 million was issued as regular tax-exempt bonds, while $221 million was issued as Build America Bonds.

“It was driven by the pricing,” Devin said. “It makes more economic sense to put the Build America Bonds out on the long end. Coupled with some IRS rules on usage, that’s how we came up with that split.”

The requirements attached to Build America Bonds can be onerous, Josten said. For instance, the Treasury can deduct any amount that a state or municipality owes the federal government, such as withholding taxes, from the subsidy payments on the bonds.

“And now they’re talking about not only deducting it from payments, but holding up the payments if they think there’s any kind of problem with that entity’s relationship with the IRS,” he said.

Record-low interest rates have also dampened enthusiasm for Build America Bonds, Josten said.

“We are hitting the point now where a lot of (tax-exempt) issues have become eligible in the last year to be refinanced,” he said, which has saved some larger cities hundreds of thousands of dollars. The Build America Bonds don’t qualify for refinancing, he said.

The Obama administration, which is pushing for Congress to extend the program, claims that the taxable, subsidized bonds are a more efficient financing tool than traditional tax-exempt bonds. Local governments will save more than $12 billion in borrowing costs compared with the cost of tax-exempt municipal bonds, Treasury officials estimate.

Critics of the program, such as Grassley, say the fees being charged to local governments to issue the bonds in many cases are benefiting big investment banks at the expense of taxpayers.

Earlier this month, Grassley asked the Government Accountability Office to investigate the program. Its structure provides “less of an incentive for the issuers of the bonds to seek the best interest rate possible on the bonds and an incentive for bond underwriters, which are Wall Street investment banks, to set higher interest rates and fees,” he said. 

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