Buy Side

A Push to Strip QSCB's Tax Credits

WASHINGTON - Rep. Bob Etheridge, D-N.C., today will urge Treasury Secretary Timothy Geithner to quickly issue guidance on qualified school construction bonds, specifically how to strip and sell the bonds' tax credit in the secondary market.

Geithner will be meeting with Etheridge, a House Ways and Means Committee member, and other lawmakers during a visit to Congress today. Lawmakers hope the Treasury will act soon to ensure a secondary market for QSCBs develops in time for school districts to issue $11 billion of these bonds before the funds revert back to the states on Dec. 31.

Only five QSCB deals have been done since February when they were created by the American Recovery and Reinvestment Act of 2009. The law authorizes another $11 billion of QSCBs for issuance in 2010.

Congress authorized the stripping of tax credits for tax-credit bonds last year, inserting a provision into the farm bill. Lawmakers reasoned that stripping the tax credits from these bonds would broaden the pool of investors for issuers to include those interested in the tax credit as well as those interested in the debt.

Though stripping has been authorized by Congress, the Treasury has not yet issued guidance detailing how it should be done. Treasury officials have said the guidance might not be released until at least September.

Investors are anxious about buying tax-credit bonds without the Treasury guidance. Some investors do not want to invest in a bond only to learn later they are unable to strip and sell the tax credit, according to market participants.

This concern could hinder the issuance of the $22 billion of QSCBs over the next two years. The bonds can be used by all school districts to finance new school construction and related land purchases.

The forerunner to QSCBs were QZABs, which can only be issued by low-income school districts to finance school renovations, not new construction. For the past 10 years, the low-income school districts were allocated $400 million per year of QZABs. Now, thanks to the stimulus, school districts have a combined $1.4 billion of QZABs and $22 billion of QSCBs to issue over the next 17 months.

A number of school districts are eager to take advantage of these tax-credit bonds. In North Carolina, the division of school support in the state's Department of Public Instruction has been "almost overwhelmed" by the interest in QSCBs from the state's 115 school districts, said Ben Matthews, the department's director.

Matthews said his office has been working with district superintendents and broker-dealer firms to find QSCB investors. On Monday, Matthews said talks between a school district and a bank in New Mexico fell through because the investor was worried about buying QSCBs without the Treasury guidance on stripping. North Carolina bond attorneys have relayed the concerns about QSCBs to Etheridge prior to the meeting with Geithner, he said.

To date, four of the five QSCB deals have been bought by Chicago-based Guggenheim Partners LLC, an investment management firm with $100 billion in assets under management. The firm has bought $85 million of QSCBs for its insurance company clients, according to its chief investment officer, Scott Minerd.

Guggenheim is currently working with underwriters and borrowers to finance more deals, he said, adding Guggenheim's clients have authorized it to buy up to $1.5 billion of QSCBs.

The insurance companies want to buy and hold QSCBs and do not plan to strip the tax credit, Minerd said.

But other investors interested in stripping the tax credit are concerned about the tax credit's independence once it is stripped from the bond's principal. The Treasury guidance must settle the problem of what would happen to a tax credit if the issuer defaults on the bond's principal, Minerd said.

"That obviously affects the secondary value of the credit. All of a sudden now, [the tax credit] is not only the claim on the U.S. Treasury, but it is conditioned upon the creditworthiness of the borrower," he said. Even if the tax credit has a separate Cusip number, "that doesn't necessarily mean it de-links" from the QSCB's principal, he said.

Other concerns have been raised by issuers who are wary of the construction requirements placed on the schools that are required to receive QSCB approval, said Michael Wadsworth, senior vice president of underwriting at Southwest Securities Inc., which underwrote the Garland, Tex., Independent School District $10 million deal.

QSCB projects must comply with the Davis-Bacon Fair Labor Act's requirements that workers be paid prevailing wages. QSCBs are not subject to whistle-blower protections or Buy American requirements, according to the Department of Education.

In the past, school districts have not had to follow these requirements, which could add a large cost, said Edward D. McLiney, chairman at McLiney and Co., a Kansas City-based investment bank that specializes in tax credit bonds.

Another hurdle issuers face in attracting investors is that the value of the tax credit has declined since the first QSCB deal, sources said. The tax-credit rate, which is set by the Treasury Department on a daily basis, was 7.87% when Guggenheim bought the first QSCB bonds. The rate dropped to 7.19% on the most recent deal. Yesterday's rate was 7.08%, according to the Treasury.

But the biggest hurdle for QSCB issuers remains attracting enough investors, market participants said. Though the potential annual supply has tripled, investors are anxious about dealing with the new product.

QSCBs "are a great way to borrow some money," Wadsworth said. "The hardest thing is finding the investors. That's the key element."

Peter Schroeder contributed to this story.


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