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Not-So-Warm Embrace

WASHINGTON - The municipal market has not yet warmed to taxable, tax-credit bonds for a number of reasons, but federal lawmakers are authorizing increasing amounts of them, most recently in the new stimulus law, to encourage the development of a market.

Proponents of tax-credit bonds, which provide investors with a tax credit in lieu of tax-exempt interest, claim that the tax credit provides a more efficient federal subsidy to state and local governments than tax-free interest payments. But critics and skeptics worry these bonds may be an attempt by Congress to undermine the tax-exempt market by pushing issuers into selling taxable debt.

Frank Hoadley, Wisconsin's capital finance director and the chairman of the Government Finance Officers Association's debt committee, said one of his "overarching concerns" is that "tax-credit bonds might be used as a tool to reduce the amount of tax-exempt bonds."

But John Buckley, the House Ways and Means Committee's chief tax counsel who helped write the tax provisions in the House's version of the stimulus package, assured bond lawyers earlier this month that the tax-credit bond programs are intended to supplement, rather than replace, existing tax-exempt bonds.

"I don't think anybody should see those provisions as a threat to tax exemption. They were not designed for that," he said during a teleconference on the stimulus law hosted by the National Association of Bond Lawyers. "They were designed to be a supplement to tax exemption and to provide state and local governments with one more financing mechanism to borrow money to finance their affairs."

The stimulus law, which was enacted last month, contains the largest single authorization of tax-credit bonds ever by Congress, and is indicative of lawmakers' continued interest in the financing tool. It authorizes an additional $27.4 billion of tax-credit bonds in 2009 and 2010 across four programs - $1.4 billion of qualified zone academy bonds, $1.6 billion of clean renewable energy bonds, $2.4 billion of qualified energy conservation bonds, and $22 billion of qualified school construction bonds.

In addition, the law permits an unlimited amount of tax-credit bonds to be issued during the next two years under the new Build America Bonds program, which allows issuers to offer taxable debt for any governmental projects. BABs provide the issuer with the option of receiving a cash payment from the federal government or having it give a tax credit to investors. The payment and tax credit would each be equal to 35% of interest paid on the bonds.

The huge authorization in the stimulus law comes after Congress in October authorized $2 billion of tax-credit bonds as part of the bailout bill that was enacted last year, the Emergency Economic Stabilization Act of 2008. Before that, lawmakers annually authorized about $400 million for qualified zone academy bonds and about $800 million for clean renewable energy bonds - the two oldest tax-credit bond programs.

But so far, muni issuers have not issued many of these bonds, despite the billions of dollars authorized.

Congress has authorized $400 million of QZABs annually for the last 10 years, capped by an additional $1.4 billion in 2009 and 2010 as part of the stimulus package. But only $1.587 billion of QZABs have been issued during the entire history of the program - less than half of the available authorization, according to Thomson Reuters.

However, a 2007 Internal Revenue Service study found that $2.4 billion of QZABs were sold in the first five years of the program, but no state issued its full allocation.

Similarly, over $1 billion of CREBs have been authorized by Congress since they were created in 2005, along with another $1.6 billion more in the stimulus law. But only $51 million of CREBs have been sold in eight transactions, Thomson's data shows.

That may have been why John J. Cross 3d, associate legislative tax counsel for the Treasury's office of tax policy, earlier this month called the stimulus provisions a "great tax-credit bond experiment."

Some muni issuers are not as charitable and insist that it is a "failed experiment."

"It's a failed experiment from Washington," said J. Ben Watkins, director of Florida's Division of Bond Finance. "What [the] House Ways and Means [Committee] is trying to do is create a market, rather than using the traditional market that has functioned very well for state and local governments over decades, and I don't think it's going to be much help."

FINDING A MARKET

The biggest problem facing issuers, when it comes to tax-credit bonds, is finding a reliable market for them, Watkins said.

"The fundamental underlying question and concern is: Who is going to buy these?" Watkins asked. "I do not believe that that market currently exists, nor do I have a great degree of confidence that it will be available."

"There is no traditional tax-credit bond market," Marvin Markus, managing director of Goldman, Sachs & Co., said during the NABL teleconference. "There may be traditional tax-credit bonds ... but there is today no traditional tax-credit bond market."

"The tax-credit bond market, generally speaking, is still in its infancy," agreed Edwin G. Oswald, a tax partner at Orrick, Herrington & Sutcliffe LLP. "[And] at least until the enactment of the stimulus bill, the volume cap for tax-credit bonds has been very modest ... Issuers and banks have been a little bit slow to focus on this because the amount of capital that could be raised through tax-credit bonds was, generally speaking, small."

"The authors of this legislation must have intended to try and get to a critical mass of authorization for these tax-credit bonds to make the market work," said Michael Bailey, a partner at Foley & Lardner LLP in Chicago. "The question is, is this enough of a critical mass?"

Buckley admitted to NABL members that the early tax-credit bond programs "have faced several handicaps that have prevented them from begin broadly available."

For one thing, Congress has placed differing restrictions on programs, requiring the Treasury to write new rules when a new tax-credit bond program is authorized. In some cases, Treasury has changed the rules over time, leaving issuers confused about the requirements.

QZABs, for example, have a somewhat tumultuous history when it comes to arbitrage regulations, bond lawyers said. Originally, QZABs were not subject to the arbitrage rebate and yield restrictions that apply to tax-exempt debt, prompting concerns from the Justice Department and the Securities and Exchange Commission that the bonds could be a prime target for abuse. As a result, QZABs were placed under arbitrage restrictions in 2006, eight years after they were created, and that led to a decline in issuance. Those restrictions were relaxed somewhat in 2008 when all tax-credit bond programs were placed under a universal framework as part of the bailout law.

"The rules of each tax credit bond program ... tend to have little differences between them, which I think really works against the commodization of the concept of the tax credit," Hoadley said.

Hoadley said that while he plans to consider tax-credit bonds, "at this point, we have not formulated any specific plans, and we're really waiting for guidance to come out."

Buckley contends that the small amounts of tax-credit bonds authorized in the past have impeded the development of a consistent tax-credit bond market.

He noted that QZABs, for the large part, have been "a niche product."

"I think most of the QZABs were probably placed privately with local banks and not broadly marketable," he told NABL members.

Hoadley agreed, saying, "I think that part of the problem is that there has been, on a relative basis, so little tax-credit bond financing done to date that people really don't have any idea whether or not there's a developed market for the bonds."

Buckley contends that Congress has laid the foundation for development of a market by broadly expanding the amount of tax-credit bonds that can be issued and by adopting a universal framework for tax-credit bonds. He also noted that tax-credit bond programs take time to get established, like the other tax-credit programs that preceded them, he said.

"The low-income housing credit had fairly low yields when it first started, but as the program became established, the yields and efficiencies of the program increased," he said. That tax-credit program was created in 1986, and today housing experts say there is more demand than supply for the credits.

Municipal market participants say tax-credit bonds could become more attractive if the tax credits are stripped from the bonds and sold separately to investors. Congress authorized stripping of tax-credit bonds last year in the farm bill.

"If it works, it could revolutionize the market" and open doors to new investors such as pension funds, foreign countries, and even state and local governments, Bailey said.

"You might have some investors who really just want taxable debt and other investors who just have an appetite for the tax benefit, and you can sell those two things to two different people," he said.

But advocates of stripping are still waiting for technical guidance from Treasury. Cross told lawyers earlier this month that while stripping rules are a priority, "they're not something we can do immediately" and that they may not be proposed for another six months.

ATTRACTION FOR LAWMAKERS

Lawmakers seem to like tax-credit bond programs because they allow them to target financing for certain projects.

At the NABL conference, Cross said tax credit bonds provide "an element of control" to the tax-writing lawmakers because they can be used to target financing for certain projects, such as renewable energy and school construction.

In fact, the Senate's top tax writer has used tax-credit bonds to effectively "earmark" funds for a pet project. Senate Finance Committee chairman Max Baucus, D-Mont., was instrumental in ensuring the $380 billion farm bill last summer contained a provision authorizing $500 million of qualified forest conservation bonds.

The program ostensibly was designed to provide tax-credit bonds to help finance the acquisition of forest land for conservation purposes. However, an analysis of the program's requirements revealed that just one project would qualify, and it is in Baucus' home state. Under the project, two conservation groups would be able to use the bonds to purchase 320,000 acres of land from the Plum Creek Timber Co.

However, the legislation contained a unique stipulation that allowed the two nonprofit groups - the Nature Conservancy of Montana and the Trust for Public Land - to obtain a $250 million check from the Internal Revenue Service without issuing a single tax-credit bond. The IRS notice outlining the requirements of the program made clear that any group seeking the full $500 million allocation of QFCBs could, instead of issuing the bonds, opt to receive a $250 million "tax refund check."

Tax-credit bonds also were used to sidestep the traditional appropriations process when funding for school construction was removed from the spending side of the stimulus package and replaced with an authorization for $22 billion of qualified school construction bonds. Buckley told bond lawyers the tax-credit bonds were "inevitable" once the proposed appropriation was cut.

Even if increased authorizations, more consistent rules, and rules on stripping ultimately encourage the development of a tax-credit bond market, there are still a number of hurdles for issuers and investors to clear, the biggest of which will be adjusting to taxable bonds, according to market participants.

"We do believe that the amount of tax-credit bonds that are being offered here ... will provide people perking up their ears, if you will, both on the investment side and the issuer side," Markus said. "[But] it will develop slower, and it will be somewhat inefficient initially while we work out the kinks."

One such kink will be understanding the daily changes to the credit rate, according to Markus.

"We are having difficulty really understanding the day-to-day fluctuations in the rate," he said.

The Treasury had set the rate based on a sampling of double-A rated bonds. But the department changed the process in January and began using a sample of lower-rated taxable bonds, ranging from single-A to triple-B, to determine the rate. The lower-rated bonds should offer a larger credit.

But Markus said the rate is "pretty volatile," and investors will need to get a handle on the new fluctuations.

Furthermore, muni issuers and investors of taxable debt will have to educate themselves on this new market.

Tax-credit bond programs will likely provide the most benefit to larger issuers who can more easily adapt to the taxable market, which normally offers investors transactions of at least $250 million, according to the Securities Industry and Financial Markets Association.

"We believe that these programs can provide added benefits for certain municipal governments with larger capital programs," said Leslie Norwood, SIFMA managing director and associate general counsel.

Michael Decker, co-chief executive officer of the Regional Bond Dealers Association, said tax-credit bonds carry "a novelty factor" and a learning curve for issuers and investors.

"Any time there's a new product, early deals are more labor intensive than when the product gets widely adopted and require a greater degree of a sales effort to generate a market," he said. "There just hasn't been widespread adoption."

Another potential hindrance is the fact that most corporations are not searching for tax breaks now due to the economic downturn.

"In the current market environment, there's probably not a strong demand for marketable tax credits, at least among corporate investors," Decker said.

Although the direct-payment option of the Build American Bonds program is garnering significant interest from muni issuers and could encourage otherwise reticent issuers to dive into the taxable market, it's unclear what the future holds for "traditional" tax-credit bonds, Decker said.

"I think the jury's still out on whether that structure in the long run ... can really be a viable alternative to tax-exempt financing," he said.

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