TAX CREDIT BONDS National League of Cities Finance, Administration and Intergovernmental Relations Steering Committee Meeting Gadsden, Alabama June 3, 2011 - PowerPoint PPT Presentation

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TAX CREDIT BONDS National League of Cities Finance, Administration and Intergovernmental Relations Steering Committee Meeting Gadsden, Alabama June 3, 2011

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Title: TAX CREDIT BONDS National League of Cities Finance, Administration and Intergovernmental Relations Steering Committee Meeting Gadsden, Alabama June 3, 2011


1
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_at_maynardcooper.com
  • (205) 254-1045

2
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.

3
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.

4
Profile of Municipal Bond Market 2007
(Pre-Crisis)
  • Rating agencies (Moodys, SP 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.

5
Profile of Municipal Bond Market 2007
(Pre-Crisis)
  • Inefficient Subsidy State and local governments
    did not receive 100 benefit of federal subsidy.
  • Why not?
  • 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.

6
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
    pre-crisis levels cost of borrowing increased by
    more than 100.
  • Municipal bond market enters deep freeze in
    Q4-2008 and Q1-2009.

7
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.

8
What are Build America Bonds?
  • Build America Bonds
  • 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.
  • Private activity bond tests apply.
  • Arbitrage rules apply.
  • Limitation in advance refundings apply.
  • No volume cap.
  • Recovery Zone Economic Development Bonds
  • 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
  • Variation allowed under ARRA but never used by
    any issuer.

9
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.

10
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.

11
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.

12
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 Februarys 787 billion
    economic-stimulus 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 efforts biggest
    successes.

13
Current Status of Build America Bond Legislation
  • Congress allowed BABs to expire on December 31,
    2010.
  • President Obamas 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.

14
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.

15
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 tax-exempt market.

16
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.

17
1901 Sixth Avenue North 2400 Regions Harbert
Plaza Birmingham, Alabama 35203-2618
205.254.1000 Fax 205.254.1999
www.maynardcooper.com
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