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Build America bonds and the sorry state of our Municipalities

June 20, 2010

I was reading an article about BAB – “Build America Bonds” which is a federal subsidy to help states and cities build roads, schools and bridges.

I then read an article that same day about “Pension obligation bonds” – where Municipalities issue bonds and use the proceeds to invest in the stock market.

We all know Pension funds face HUGE shortfalls in funding so that got me thinking – is their a chance that Municipalities are issuing debt to “build America” and simply using the proceeds to speculate on the stock market…??

Build America bonds for pensions: I would call these “Sustainable Pension Incentive Funding” (SPIF) bonds. Some public finance professionals may consider controversial because it goes beyond traditional infrastructure finance. Congress and the Administration should also expand the BAB program’s taxable bond option to include qualified pension obligation and OPEB obligation bonds, but with fiscal strings attached and a far lower subsidy rate of 15 percent — plus a two-year sunset with a mandatory review by the GAO. The idea should be that federal support of proper pension and retirement plan financing will avoid future financial crises, and would actually stimulate the U.S. capital markets, as I’ll explain below.
A federal subsidy on “SPIF” bonds should be limited to 10 years. During that period, the recipient of subsidy must pay its full actuarially required retirement plan contributions in years 6-10, as well as annual debt service and the full actuarial normal cost in years 1-10, or else lose the subsidy. Likewise, employee benefits increases would be prohibited during the subsidy period, so that the federal taxpayers’ subsidies do not spawn another round of retroactive benefits increases that boomerang on local taxpayers.
The proceeds of a SPIF bond issue should be invested in a separate trust fund as I described in my previous column on Benefits Bonds legislation. Investments should be limited to U.S. stock-exchange listed stocks and government bonds, so that taxpayers are not subsidizing insurance companies and hedge fund managers making 2 percent management fees plus carried interest on taxpayer money. Putting that money directly to work in the stock market would stimulate economic activity and actually improve the condition of pension and 401(k) plans from the market impact.

Oh brother

Here is an article explaining the farce that BAB bonds are even if not used to speculate on the stock market – I love the part where Municipalities dont take to subsidy in order to avoid paying back taxes. What a joke. Why should I pay taxes when States refuse and get away with it?

rian Branch Price/Bloomberg News

A highway project in New Jersey, a major seller of subsidized Build America Bonds.
An elementary school being built in Chesterfield, N.J. The state sold $750 million in subsidized Build America Bonds recently. But Build America Bonds, part of President Obama’s economic stimulus plan, are also building something else: controversy.

States and cities have embraced these taxable bonds to borrow money at what they assume are favorable interest rates. The federal government pays 35 percent of the interest costs on the bonds, a huge potential saving.

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.

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.

The Obama administration wants to make the program permanent, but Senate Republicans last week 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 from 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. (That number 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.”

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, analysts are asking whether the program is needed now that the worst of the financial crisis is over. 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.

Here is an article on “Pension obligation bonds”


ccording to the Wall Street Journal, state and local borrowing as a percentage of U.S. GDP has risen to an all-time high of 22% in 2010.
A popular weapon in the debt arsenal is the so-called pension-obligation bond. For two decades, governments have played a risky game in which they issue bonds and then deposit the money in their pension funds to be invested in the stock market with the hope that the money outperforms the debt. These bonds have become fiscally toxic. As the Center for State and Local Government Excellence noted in a report earlier this year, most pension bonds issued since 1992 have been money losers for states and cities, exacerbating severe underfunding of pension systems in places like New Jersey.
Pension Bond Madness

Even though pension bonds issued since 1992 have been money losers for states and cities., professor Joshua D. Rauh, at the Kellogg School of Management, Northwestern University, has proposed Pension Security Bonds in a New Plan to Address the Pension Crisis.

While I agree with several aspects of professor Rauh’s plan, pension bonds is certainly not one of them.

I am exceptionally leery of new government programs because the programs always cost more than expected. The proposed “Pension security bonds” will prove to be no different.

For starters, I sincerely doubt we see 8% returns on average for a very long time. Indeed it would not surprise me to see negative stock market returns for a few more years.

Japan had two lost decades and it looks like we are headed that way as well. Even flat returns would be a disaster for pension plans.

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