2009: A Boon for Bonds?

WASHINGTON - The coming year will mark a reversal for tax-exempt bonds in Washington, as Congress and the new administration focus on using them to help stimulate the economy rather than on restricting them to curb federal revenue losses, market participants said in interviews on the outlook for tax legislation and regulation.

"I think that Congress will be looking at ways to assist state and local governments, and one of the ways they will be doing so will be through the bond market," said Susan Gaffney, director of the Government Finance Officers Association's federal liaison center here.

Charles Samuels, a lawyer with Mintz Levin Cohn Ferris Glovsky & Popeo PC here, counsel to the National Association of Health and Educational Facilities Finance Authorities, said bonds will play a key role in next year's efforts to get the economy back on track, and provide a great opportunity for a number of legislative priorities.

"[Lawmakers] hopefully understand the need for state and local governmental financing and its role in infrastructure and stimulus," he said.

However, market participants intend to keep a watchful eye on developments in Washington to ensure that the anticipated push for more regulation of the financial markets does not come down too heavily on the tax-exempt bond market.

As lawmakers and the incoming administration look for ways to stimulate the lagging economy, the increased use of tax-exempt as well as tax-credit bonds are being considered.President-elect Barack Obama announced in a Dec. 9 radio address that he has directed his economic recovery team to focus on infrastructure, school modernization, and energy-efficient buildings as key components of any plan. Municipal bonds have been a key financing tool in these areas.

Senate Finance Committee chairman Max Baucus, D-Mont., said earlier this month that he wants to include in the forthcoming economic stimulus legislation a provision that would allow governments to issue additional private-activity bonds, not subject to the alternative minimum tax, for infrastructure projects. That bill could total over $500 billion, and Baucus said the tax provisions could account for half of that total.

HELPING THE MARKET

There are many ideas under consideration for legislation right now, but the main goal is to find a way to get the muni market moving again, according to its participants.

"We've got lots of projects that people want to do and they can't do it. It's very hard to get to market right now," Samuels said. "There are projects everywhere ... that can get in gear if [the market] loosens up."

While state and local governments could use additional funding from the federal government, there are also a number of relatively small bond-related legislative changes that could help stimulate the muni market, sources said."While the big stimulus packages and the big ideas are good, there's probably five to 10 little technical changes to the code that are not cost-prohibitive ... that can be easily implemented and make significant changes," said Toby Rittner, president and chief executive officer of the Council of Development Finance Agencies, which was initially created to support small industrial development bonds but now has a broader agenda.

A top priority for many muni groups is to get lawmakers to increase to $30 million from $10 million the tax code's so-called bank deductibility limit. Currently, banks are allowed to deduct 80% of the costs of purchasing and carrying tax-exempt bonds issued by states and localities whose annual bond issuance does not exceed $10 million.

In addition to raising that cap, the groups want borrowers that sell bonds through conduit issuers to be allowed to qualify as small issuers by electing to apply the $30 million issuance limit to themselves rather than at the issuer level.

Both Gaffney and Samuels said getting those provisions in legislation is one of their top priorities going into 2009.

"It'll help small issuers, as well as all issuers, by allowing banks to be back in the game," Gaffney said. "Bringing them back into the fold ... can be nothing but positive."

"It's exactly compatible with the [stimulus] package," Samuels added. "It makes sense to liberalize bank deductibility for small issuers and small charities."

Another potential stimulus provision being encouraged by several sectors of the muni market is the removal of the AMT from varying types of private-activity bonds. The tax, which applies to interest earned on private-activity bonds and some governmental and 501(c)(3) bonds, was created to prevent high-income households eligible for several tax breaks from paying little or no taxes. However, the AMT is not indexed to inflation, so more taxpayers become subject to it each year.

President Bush signed the omnibus housing bill during the summer, which contained a provision exempting all housing bonds from the AMT. But muni market groups are pressing to have more bonds exempted from the tax.

CDFA's Rittner said that his organization is encouraging Congress to take up legislation that would exempt industrial development bonds from the AMT.

"It's really an antiquated, outdated concept," he said. "The numbers don't make any sense anymore."

GFOA's Gaffney and Ed Oswald, a partner at Orrick, Herrington & Sutcliffe LLP here and former Treasury attorney adviser for bonds, said airport bonds should be considered for AMT relief.

"I think it would be a benefit to the industry to revisit the AMT question with respect to airport bonds as well, given difficulties in that industry and the additional premium paid by issuers with respect to AMT bonds," Oswald said. The fact that airports have struggled recently to finance their projects makes a strong case for AMT relief, he said, adding that "from a tax policy perspective, it makes sense. It recognizes that there's different budget pressure."

"It is a way of saving issuers money and that is something that we need to be doing, especially now," Gaffney said.

The American Association of Airport Executives has pressed Congress to include a repeal of the AMT for airport bonds in the stimulus package, saying the tax, coupled with the overall market downturn, has made the PAB market nearly inaccessible to airport issuers.Lawmakers are listening to these pleas. House Ways and Means Committee member Richard Neal, D-Mass., introduced legislation this month that would exempt all PABs from the AMT and plans to reintroduce it when the next congressional session convenes in January.

Market participants also are expecting to see a lot of legislative activity for tax credit bonds during 2009.

The $700 billion financial bailout package that Bush signed into law in October included a number of "extenders" or provisions that would extend or reauthorize tax breaks, many of them bond-related, including a one-year "patch" to the AMT.

The new law also created or reauthorized several categories of tax-credit bonds, including Midwestern disaster-area bonds; qualified zone academy bonds; qualified energy conservation bonds; clean renewable energy bonds; and qualified green building and sustainable design project bonds.

With the Obama administration's focus on infrastructure, schools, and energy efficiency, tax-credit bonds could play a major role in any upcoming legislation.

"I tend to think we'll see more tax-credit bonds with the new administration's focus on renewable energy," Oswald said. "We could see deeper funding levels of CREBs and we could see other variations of tax-credit bonds or initiatives that focus on clean energy, the environment, and other administration priorities."

However, Oswald warned that while tax-credit bonds can be a help, tax-exempt bonds would be more immediately effective in stimulating the economy.

"The tax-exempt system right now is a very viable, robust system," he said. "It's a system that everyone knows, and arguably you could make those changes more quickly [with tax-exempt bonds] than trying to create a new brand of tax-credit bonds."

Because each new category of tax-credit bonds requires a new set of guidance from the Treasury Department, their utility to the market could be delayed as issuers wait for rules, whereas any proposed changes to tax-exempt bond requirements could take effect more quickly, he pointed out.

While there are a number of legislative opportunities for the bond market in the coming months, some market participants are concerned about how the muni market might be affected if lawmakers turn their attention to a new round of financial regulations.

"Obviously, there's going to be a lot of talk on financial re-regulation," Samuels said. "We're very concerned about that, and that it be handled sensitively."

He added that recent struggles in the muni market were largely due to "totally extracurricular activities by bond insurers and banks ... having nothing to do with the bond issues."

"Somebody without a lot of knowledge about the municipal market ... could take some action that would adversely affect us," he warned.

Samuels called for "balanced, useful" actions from Washington, and pointed to the Securities and Exchange Commission's recent approval of the Municipal Securities Rulemaking Board's EMMA system as a central disclosure repository as an example.

REGULATION

On the regulatory side, market participants are expecting another busy year at the Treasury, but are not as certain what areas will be the focus of its resources.

Although the Treasury and Internal Revenue Service have already released their priority guidance plan for projects to be completed by July 2009, many are unsure how the economic downturn will affect those projects.

Their agenda includes finalizing regulations that streamline the public approval process that an issuer or borrower of a PAB-financed project must adhere to under the Tax Equity and Fiscal Responsibility Act.

When the proposed regulations were released in September, market participants said they would provide much-needed relief from the public approval process that they considered arduous. But issuers cannot take advantage of the new rules until they are finalized, leading them to call for the Treasury to act quickly. The department, however, will have to take into account the fact that several labor groups are opposing the proposed rule changes, arguing they will restrict public input.

Treasury officials have said they would like to finalize the rules as soon as possible, and have scheduled a public hearing on the proposed rule changes for Jan. 26.

The Treasury also wants to finalize the allocation and accounting rules for the private use/private payment test, which had been proposed in September 2006, as well as produce further guidance on derivatives, particularly interest rate swaps, in the wake of the financial crisis. The IRS' bond branch has already stated it will be increasing its focus on derivatives in the coming year as a result of the crisis.

Oswald said the allocation and accounting rules are "something people have been waiting for awhile, and I think that is a priority of the regulators to get those finalized."

"Any further clarity or guidance regarding derivatives and interest rate swaps would be very helpful," he added.

But market participants worry that the financial crisis will create other priorities for the Treasury and the IRS.

"They intend to work on one thing, but then they get a higher priority, said Tom Vander Molen, a partner at Dorsey & Whitney LLP in Minneapolis. "Right now, Treasury is real concerned about the economic crisis, so it's saying, even to the IRS, 'We want you to put your focus on things that will affect the economy.'"

Further, much of Treasury's agenda for 2009 will depend on what the department ultimately has to address as a result of any new legislation, particularly the stimulus bill."If there's new legislation, that's going to tie them up," Vander Molen said.

"If in fact we see a very robust infrastructure initiative from the administration, that could take away from some of the manpower at Treasury that would be otherwise dedicated to finalizing and publishing regulations," Oswald said. "That's really just how the system works ... There could be perhaps some slowdown if people at Treasury are very, very busy with legislation."

For example, as a result of the housing law enacted this summer, the Treasury has had to work on guidance regarding the allocations of the additional tax-exempt bond volume cap that was granted under the law, as well as other tax-exempt bond provisions. Furthermore, the enactment of the "extenders" package as part of the financial bailout legislation has put pressure on the Treasury to draft and release guidance for those provisions as well.

Another variable that could determine Treasury's regulatory agenda in 2009 will be who replaces Eric Solomon as the Treasury Department's assistant secretary for tax policy and top tax expert. Solomon is expected to leave the post in January amidst the transition to the Obama administration. No formal candidates have been announced for the slot.

Samuels said whoever is ultimately chosen to fill that post will play a "significant role" in guiding the Treasury's actions in the tax-exempt bond sector. Samuels said he and other market participants will be asking, "What do they know about muni bonds?"