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'Taxable Bond Option'?

WASHINGTON - Municipal market participants are concerned about the so-called taxable bond option programs proposed in the economic stimulus packages pending in the House and Senate, questioning how effective they would be and even worrying that they could ultimately undermine the tax-exempt bond market.

Dubbed Build America Bonds in the Senate bill and the tax-credit bond option for state and local governments in the House bill, the proposed programs would allow muni issuers to sell taxable debt in 2009 and 2010 in exchange for a cash subsidy from the federal government. For taxable bonds issued after that, the government would provide investors with a 35% tax credit.

The House bill would make the tax credit option permanent for taxable bonds issued after 2010, but the bill pending in the Senate would apply the tax credit option only to bonds issued in 2011, after which the program would expire.

Similar proposals have been floated over the decades, most recently in 1994 as part of former President Bill Clinton's infrastructure funding plan. Proponents claim that a taxable bond with a cash subsidy/tax credit option would provide a more efficient and consistent subsidy than federal tax exemption of the interest earned on state and local muni bonds. Against the backdrop of the credit crunch, the program would allow tax-exempt issuers struggling in the search for buyers to take their debt to the larger taxable market to find new investors, they contend.

However, some market participants worry that the program would make state and local issuers too reliant on the federal government or that it would not be effective in providing relief to issuers.

A major concern is that issuers selling these bonds would have to rely on the federal government to continue to provide the cash subsidy or tax credit over the life of the bonds, which could span decades. They wondered how the muni market can count on lawmakers to continue the programs if they are faced with a skyrocketing budget deficit or other political pressures.

"Under a taxable bond option, there's some attractive terms, but it depends upon the federal government ponying up a certain amount," said one market participant who did not want to be identified. "I wouldn't go to the bank with that promise."

Several market participants warned that, in a worst-case scenario, tax-exempt issuers might flock to the taxable market, rendering the tax-exempt market less viable. They fear that once issuers became invested in the taxable bond market, the federal government would begin reducing the subsidy and credit.

"You get people moving in one direction, get used to providing a federal subsidy to get people to do what they normally wouldn't do, and then you roll that back over time," said another member of the bond community who did not want to be identified.

Lawmakers and federal officials are already struggling with their efforts to encourage taxable tax credit bonds in a growing number of sectors of the market like renewable energy and education, he added.

"[Congress has] tried these tax credit bonds repeatedly, they are in love with tax credit bonds, and tax credit bonds do not work," he said, pointing to a growing number of taxable tax credit bond programs implemented in recent years.

Susan Gaffney, director of the Government Finance Officers Association's federal liaison center, said GFOA has been opposed to the idea since it first surfaced in 1969.

Issuers have warned that the provision would raise their issuance costs because transaction participants would have to be educated on the program's mechanics and the new market, she said. In addition, the program could open the door to increased federal involvement with state and local governments.

"There is some concern that ... down the road this could lead to the federal government imposing restrictions on the way state and local governments can issue bonds," she said. "Congress should be looking at ways to help the tax-exempt bond market ... rather than experimenting with it."

Other market participants agreed that Congress should take steps to help muni issuers access the tax-exempt market, rather than attempt to provide them with an entirely new market.

"There could be more efficient and effective ways for the federal government to support the muni market, and this is a time when those mechanisms that support the existing traditional market need to be used rather than experimentations," the bond community member said. "This is not a petri dish, a test tube."

"It's a market that investors understand, that the Street understands, and it's worked for a long time, and now you're introducing something that's untried and untested," another market participant said.

Carol Lew, a shareholder at Stradling Yocca Carlson & Rauth in Newport Beach, Calif., stated that she is "appreciative of the lawmakers' efforts to help state and local governmental units and the tax-exempt bond market."

But she noted that while it is helpful to give issuers as many options as possible, "there is increased complexity introduced into the financing process whenever new programs are created and there may be a need to develop the market for such new financings. Tried and true financing methods can be effective tools to assist in generating economic stimulus."

A spokesman for the Securities Industry and Financial Markets Association said yesterday that the group does not have a position on the proposed taxable bond option program and that its analysts are still studying it.

Michael Decker, co-chief executive officer of the Regional Bond Dealers Association, said that a taxable bond option program could help some large issuers, but not most.

"I think for a large number of muni issuers, the way that the taxable bond market works will make it tricky for them to be able to sell bonds using this program at a reasonable cost," he said.

Taxable investors typically look for issue sizes of more than $100 million, as well as corporate disclosure practices such as audited annual reports, and taxable muni bonds, which typically would be smaller and have less disclosure, could be "a tough sell," he said.

"That's not to say that the idea of a taxable bond option or a tax credit bond is wholly without merit, but I don't think it's a good substitute for a large group of issuers," Decker added.

He downplayed concerns about Congress rolling back subsidies and credits in the future.

"Frankly, Congress could decide to change the law with respect to the tax exemption as well, that's not written in stone," he said. "The fact that Congress could change the rules midstream, I think, is an issue that at least some investors are comfortable considering."

But Decker emphasized that the taxable bond option should remain strictly an option.

"The one thing that gives me comfort is that this is being presented as an option for issuers, it's not a requirement that issuers have to use this program," he said. "As long as it remains an option for tax-exempt finance, for those issuers that can't take advantage of it, it's harmless."

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