WASHINGTON - State and local governments need prompt guidance from the Treasury Department before they can issue the new taxable Build America or Recovery Zone bonds for cash subsidies or investor tax credits, market participants said last week.
The need for the quick guidance is exacerbated by the fact that most muni issuers would be entering uncharted territory in the taxable market, and the economic stimulus law that authorizes the new bond programs provides only a 24-month window to take advantage of them.
Both programs allow issuers to offer taxable debt and either claim a direct subsidy from the federal government or provide a federal tax credit to investors. However, it's unclear if issuers will opt for the subsidy and how they would receive it.
"I think one of the big questions really is how the refund procedures are going to work," said Gary Bornholdt, a lawyer at Nixon Peabody LLP here. "I think they're going to have to provide at least some sort of initial guidance that says, 'This is how you make the option ... and the refund procedures are going to be this way.' "
"This is really a new type of program," said Michael Decker, co-chief executive officer of the Regional Bond Dealers Association. "As far as I know, the Treasury never has offered this kind of a subsidy in this manner before."
Decker thinks the Build America bonds will be most appealing to larger issuers, because they will be better able to adapt to the taxable bond market.
"The taxable bond market tends to be dominated by issues that are relatively large in size, $250 million or higher, with very well-defined bullet maturities," he said. "That's generally not the kind of debt service schedules that most municipal issuers are used to, so I think the issuers that are most able to take advantage of that program are issuers who can issue in size, who are strong credits and who are able to adapt their borrowing patterns."
Patrick McCoy, director of finance for New York's Metropolitan Transportation Authority, agreed with Decker's assessment. The MTA, which plans to issue $2.59 billion of debt this year, is considering the Build America bonds program, but is also waiting for guidance.
"Preliminary indications are that an issuer of our size would benefit from the Build America bonds," McCoy said. "The concern is probably for those ... issuers who are smaller."
"At this point, it's still fairly preliminary in terms of how we would assemble a deal," he said. "We're certainly waiting to see [the guidance] along with everybody else in the market."
Leonard P. Wales, debt manager for Fairfax County, Va., is also waiting for specific details from the Treasury, and says he will be interested in seeing how the taxable market will react to muni issuers.
"How will the markets respond?" he said. "The issue will be market receptivity .... Somebody's actually got to go out and try this."
Wales said that if Fairfax County issued taxable debt, it likely would opt for the direct subsidy option under the Build America program because the market might apply a discount to tax-credit bonds.
"Whoever is buying those tax credits might look at pricing those a little differently than the straight reimbursement from the federal government," he said. "Can I sell taxable bonds at rates that are less than 35% discounted to my tax-exempt rate? That's going to be the key."
The subsidy option would provide a better return for issuers, several lawyers said. First, the tax credit would be taxable to investors, whereas a subsidy to a state or locality would not. Furthermore, tax credits typically have to be sold at discount in order to appeal to investors. An investor, for example, would not pay $1 for $1 worth of credit, but rather only 90 cents. The subsidy option would allow the issuer to realize 100% of that benefit.
The Build America bonds program would provide a credit or subsidy equal to 35% of the interest rate on bonds issued in the next two years, while the taxable portion of the Recovery Zone bond program would provide them at a 45% rate. The law authorizes an unlimited number of Build America bonds to be issued in 2009 and 2010 and up to $10 billion of the Recovery Zone economic development bonds during the two years.
Issuers would only qualify for the subsidy under the Build America program if the bond proceeds are used exclusively to finance capital expenditures, minus issuance costs and a reserve fund. Under the Recovery Zone program, issuers receiving the subsidy would not face this restriction.
Even though the bonds are taxable, they still will have to comply with underlying tax-exempt bond restrictions. Issuers will not be able to invest their bond proceeds to earn a substantial profit in accordance with arbitrage rules and they will have to limit the amount of proceeds used for private purposes.
Market participants that want to issue other tax-credit bonds or private-activity Recovery Zone facility bonds authorized by the economic stimulus law are waiting for the Internal Revenue Service to determine what amounts of the bonds will be allocated to states.
The new law includes more money for existing tax-credit bond programs such as the qualified zone academy bond program, and also creates new types of tax-credit bond programs such as the one for qualified school construction bonds.
Many of these programs contain special stipulations, such as that 40% of the $22 billion of qualified school construction bonds must be allocated to large school districts. The $15 billion of private-activity recovery zone facility bonds are to be allocated among states based on the growth in their unemployment rates since 2007.
The law says that every state must receive at least 1% of the total authorization. As a result of these requirements, market participants want to see the IRS' allocations before committing to issuing bonds.
Without federal guidance, "it would be very difficult to give comfort to an issuer that they have not allocated more than their allocation," said Linda Schakel, a partner at Ballard Spahr Andrews & Ingersoll LLP.
Although nothing has been released yet, Treasury officials have indicated that publishing guidance on stimulus provisions will be a top priority for them this year.
John J. Cross 3d, tax legislative counsel for the Treasury Department's office of tax policy, told bond attorneys at an American Bar Association meeting last month that other agenda items would have to take a backseat to the stimulus package. He could not be reached for comment last week.
However, Treasury officials appear to face some obstacles in moving forward. The presidential transition has left the Treasury without an assistant secretary for tax policy and top tax expert. The post has been vacant since Eric Solomon left the department in January. Although many subcabinet appointments requiring Senate confirmation have been made in other departments, the Treasury has not filled any of those spots yet.
Treasury Secretary Tim Geithner's unpaid taxes may be slowing the appointment process for the remaining spots, sources said, as complicated tax returns are being thoroughly dissected for potential errors or oversights.