Build America Bond Success Carries a High Price Tag

WASHINGTON - Municipal market participants are warning that the federal government may have underestimated the revenue impacts of the Build America Bonds program so that it is far more costly than anticipated. They also are concerned that issuers may not receive federal payments under the direct-pay BAB program if they are used to "offset" taxes or other money owed to the government.

The BAB program, which was authorized by the stimulus law enacted in February, allows municipal issuers to sell an unlimited amount of taxable debt in 2009 and 2010 and either receive a direct cash payment from the federal government or have the government provide investors with a tax credit.

While issuers initially were wary of the program, they found the direct-pay BABs to be attractive. Since the program began two months ago, 86 issuers have sold nearly $12.5 billion of BABs, according to Thomson Reuters.

But the surprising popularity of the financing tool and the confusion about how its effects on revenue should be estimated has left the federal government with a much higher than anticipated price tag.

From the beginning, lawmakers and federal officials struggled with predicting the cost of the unprecedented program, offering numbers that varied widely and that already seemed insufficient compared to the amount of bonds issued in the first two months.

The congressional Joint Tax Committee in February estimated the federal government would spend $51 million in fiscal 2009 and $292 million in fiscal 2010 on the BAB program.

President Obama's budget request, released in May, contained two different sets of numbers. The section of the budget on federal grants to states and local governments estimated the program would cost $50 million in fiscal 2009 and $192 million in fiscal 2010. The appendix showing the Treasury Department's budget request estimated the government would spend $91 million in fiscal 2009 and $340 million in fiscal 2010 on BABs.

However, Philip Fischer, the municipal bond strategist forBank of America-Merrill Lynch, said Washington is likely to spend far more on BABs. He estimates the government is already on the hook for $250 million of annual payments after only about two months of BAB issuance and could see a "cash flow of a couple of billion a year" by the time the program sunsets at the end of 2010.

"The scoring of the provision was relatively modest, " Fische said. "I think that when you actually sit down and look at the amount of payments which the Treasury is committing itself to, the numbers are getting to be pretty large."

Federal officials have pointed out that the cost estimates for the program were made as the authorizing legislation was being drafted and well before the program became popular. Lawmakers opened the door to high levels of issuance and significant costs after they did not limit the size of the program.

Fischer suggested that the lower estimates may have been based in part on the assumption that BABs would be purchased by traditional investors of tax-exempts who typically are wealthy and have tax rates as high as 35%. But BABs, which are taxable, are more likely to be purchased by foreign investors or pension funds - which don't pay income tax - or by investors with lower tax rates. His firm estimated BAB investors may have tax rates that average only about 11%.

Fischer said the cost of the BAB program is "neither good nor bad as far as [the firm is] concerned," but added that the program may be so costly that lawmakers are loath to extend it beyond 2010, especially as they struggle with growing federal deficits.

Some issuers also have lingering concerns about whether lawmakers can be counted on to provide BAB payments to them over the decades-long life of the bonds. Treasury officials have attempted to assuage those concerns by pointing out that the payments are treated as tax refunds that are not subject to the traditional appropriations process and the political pressures that come with it. Lawmakers would have to change the law to stop BAB payments.

But because the payments are treated as tax refunds, the federal government has the ability to retain them to offset any taxes - such as payroll taxes - the issuer owes the government. The preliminary guidance on BABs that the Treasury released in April states the federal government can use the payments to offset outstanding tax liabilities. Issuers want to know whether unpaid taxes would include arbitrage payments, closing or settlement agreement penalties, or other money owed in addition to payroll taxes.

Frank Hoadley, Wisconsin's capital finance director and the chairman of the Government Finance Officers Association's debt committee, said the potential for payments to be used to offset unpaid taxes is "troublesome."

Standard & Poor's said in a report earlier this month that when rating BABs it will take into account whether an issuer that pledges or intends to use the federal payments for debt service has the resources to make up for any payments it does not receive.

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