Investors, Pols Love Expiring Bond Subsidy

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A telling moment in the life of any federal spending or subsidy program is when it's about to expire. That's when the program's beneficiaries can be whipped up into frenzy as they look to cash in before the money goes away.

We are seeing just such a frenzy now in the market for Build America Bonds as state and local governments rush to get out new issues before the program terminates at the end of the year. At the same time, many of the players in the market are angling to make sure the good times roll on by lobbying Congress for an extension of BABs. Some even want to make them permanent. Taxpayers beware.

BABS are a special brand of taxable municipal instrument created by the federal government in April 2009 for states and municipalities to offer to investors who don't traditionally buy municipal bonds. Thanks to a rich federal subsidy that allows issuers to offer attractive interest rates on these bonds, BABs have proven enormously popular with buyers, including foreign investors who don't benefit from the tax-exempt status of most municipal bonds. They've jumped in to purchase the bonds from fiscally challenged governments like California and New Jersey that were having trouble borrowing as their own budgetary crises developed starting in late 2008.

Investors are lured not only by the federal subsidy, but also because of an implicit sense that the federal government would never let a BAB offering default. Hence the notion that these bonds are ‘safe,' as reflected by a recent headline in the financial press: "BABs woo investors with yield, safety....prove sweet alternative to corporate (bonds)."

With such a surefire formula, local governments don't want this program to go away. Some 70 different lobbyists are registered in Washington to lobby for BABs, according to press reports. You can bet that most of them have been employed to get the program extended.

Among those spending their money on high-priced lobbyists is the "fiscally strained" University of California, which according to The Bond Buyer trade publication has hired several reps in Washington to work toward extending BAB. New York's Metropolitan Transportation Authority, struggling with a $900 million deficit despite three years of fare increases, has also signed on a lobbying firm to push for more BABs. The agency, deeply in the red in part because it hasn't been willing to face down unions and grab control of its soaring pay and benefit costs, has issued $3 billion in the new debt.

The big Wall Street firms have also lined up to push the bonds because they represent a lucrative underwriting opportunity. Since their inception, governments have issued more than $123 billion in BABs, a welcome additional business for financial firms from governments that might otherwise be sitting on the debt sidelines.

BAB debt has helped add to the growing municipal borrowing that's outstanding in America, which has increased by about $100 billion since the financial crisis began. When you add that to the other outstanding obligations of states and cities, some of which simply haven't been paying their bills in the past two years, the total burden represents 22 percent of gross domestic product, a near doubling of the state and local debt load in the past 30 years.

New Jersey, for instance, is using BABs to replenish its exhausted transportation trust fund, which politicians have raided over the years. Financed by gas taxes that are supposed to pay for roads, bridges and tunnels, that money has instead gone into the state's general fund and been replaced with borrowing, so that increasingly the state's gas tax has gone to pay off debt, not to purchase new infrastructure. Jersey would have had to shut down its road construction projects were it not for the federal largesse in the form of BABs. This is what stimulus is often about, bailing out the irresponsible.

BABs were supposed to pay for essential infrastructure, but states and cities today have a curious definition of what's essential. Dallas, for instance, floated some $338 million in BABs to build a subsidized downtown convention hotel that no private company would finance on its own. The hotel is meant to buoy Dallas' convention business, which is suffering along with that of other cities because many municipalities rushed to build convention space with borrowed money to the point where America now has perhaps 40 percent more capacity in the heavily subsidized industry than it needs.

BABs backers tout the program because it has cost little relative to other stimulus efforts. The CBO estimates the federal subsidy for the bonds will cost $36 billion over 10 years, which (though $10 billion higher than originally estimated) is chickenfeed these days in Washington.

Those estimates, of course, don't include the misallocation of resources as investors who might otherwise buy corporate securities line up for this too-good-to-be-true deal courtesy of Uncle Sam. A story this summer in Investors Business Daily quoted a bond-fund manager who compared New York City bonds with those issued by Wal-Mart and noted that a combination of higher rating and higher yield favored the muni. "What investor wouldn't prefer that?" the fund manager asked. He neglected to mention the extra yield was a gift from Uncle Sam, and that it was New York City, not Wal-Mart, that would have defaulted on its debt in the mid-1970s had it not been bailed out by the federal government and the state.

That is the real cost of luring a whole new investor into the municipal debt market, a foreign investor who is betting that this debt is backed by the federal government. States and localities have been irresponsible enough with their own municipal borrowing over the years, increasingly using muni debt to finance everyday operations, build questionable projects like sports stadiums or museums, and subsidize politically connected businesses at great risk to taxpayers.

BABs have now increased the moral hazard in the muni market. No wonder that states and cities don't want the program to die.


Steven Malanga is an editor for RealClearMarkets and a senior fellow at the Manhattan Institute

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