The looming sequestration cuts, including those on Build America Bond payments, will likely be higher than estimated, some municipal bond market participants are warning.
Following the Jan. 2 enactment of the American Taxpayer Relief Act of 2012 (ATRA), also known as the “fiscal cliff” agreement, tax experts revised their estimates on how sequestration — the automatic, across-the-board budget cuts — would impact federal programs.
Sequestration had been scheduled to go into effect on Jan. 2, but under the ATRA it was postponed until March 1 and Congress reduced the amount of cuts for fiscal 2013 to $85.3 billion from $109.3 billion after offsetting the delay by achieving $24 billion in savings from defense spending cuts and revenue increases.
OMB initially estimated that BAB payments for fiscal year 2013 would have to be cut by 7.6% or $255 million. After ATRA was enacted, the Center on Budget and Policy Priorities estimated that BABs and other non-defense discretionary programs would only have to be cut 5.3%.
But several muni market participants noted that the 5.3% is an annualized rate and the time frame during which the cuts must be taken was reduced to seven from nine months, leaving greater cuts to BAB issuers receiving payments between March 1 and Sept. 30.
“People shouldn’t assume that it’s just 5.3%, it’s probably going to be a larger number,” said Bill Daly, director of governmental affairs for the National Association of Bond Lawyers. “If you are getting a BAB payment in April, it’s hard to tell what that number will be.”
Matt Fabian, managing director with research firm Municipal Market Advisors, agreed with Daly, saying, “The first year sequester impact will be higher because it’s across a shorter time frame.”
There is still uncertainty about what will happen on March 1.
An administration official said it remains to be seen exactly how the sequestration will be ironed out and what the final percentage of cuts will be as of that date.
Nick Samuels, a vice president on the state ratings team with Moody’s Investors Service, echoed the administration official, saying that, while the timing for the sequester cuts is compressed, it’s unclear “exactly what will happen with sequestration or what form it will be in.”
Sequestration cuts to BAB payments would validate fears that muni market participants have expressed about the program since it was created in 2009 under the American Recovery and Reinvestment Act. State and local officials have warned that while the Treasury sends issuers payments equal to 35% of their interest costs, that department or Congress can reduce or take away those payments at their discretion.
Muni market participants say that while most BAB issuers are large and can handle cuts in payments, smaller issuers may be hurt the most.
“There is the potential exposure that cities will be on the hook for the remaining difference of what is owed and what is not being paid by the federal government,” said Lars Etzkorn, program director for the National League of Cities. “Sequestration is really bad policy. It certainly will retard capital investment in our local communities.”
Jim Thares, city clerk with Avon City, Minn. said if the city received less in BAB subsidy payments, “it would drastically concern me.”
“The biggest elephant in the room is our debt and our debt service,” Thares said. Avon City, which issued $560,000 of BABs in May 2010 and is one of the smallest BAB issuers, will be servicing approximately $300,000 in debt service on BABs and other debt starting next year, which is significant for the small town of just 1,400 residents.
Nevertheless, even the larger issuers are upset about what they call a change in the rules and the potential loss of confidence from investors.
“We think it’s unfair for Congress to change rules of the game midstream,” said Virginia State Treasurer Manju Ganeriwala, president of the National Association of State Treasurers.
Virginia and other states have been planning for the sequestration cuts since they were first mentioned in 2011 by increasing liquidity, she said.
Virginia created a federal action contingency trust fund to prepare for federal spending cuts and has nearly $50 million in it, Ganeriwala said, adding that any difference in BAB subsidy payments would come from this fund.
“Cash is king,” she said. “In these uncertain times that’s what state and local governments are doing. At least in Virginia, we are very fiscally conservative and we do responsible budgeting.”
Virginia expects $24.1 million in BAB payments from the Treasury for fiscal year 2013 and has received $21.4 million to date, according to the Treasurer’s office.
Reducing Investor Confidence
David Parkhurst, director of the National Governors Association’s economic development and commerce committee, said the uncertainty of direct-pay bonds for state and local issuers is chipping away at investors’ confidence levels.
“It’s like a water balloon; you are squeezing the bubble until the very end,” he said.
Fabian noted that while the BAB subsidy payment cuts might make a substantive difference for some issuers, the majority of issuers who sold BABs were large and generally liquid.
“That doesn’t mean there are some issuers who are relying on it, won’t find themselves discomforted,” he said.
Moody’s Samuels echoed Fabian and said most issuers should be able to manage the payments.
“Relative to the size of their revenue, it is not something that most issuers shouldn’t be able to deal with,” Samuels said.
California was the number one BAB issuer from 2009 through 2012, with seven deals totaling $13.54 billion, according to Thomson Reuters.
For the fiscal 2012-2013 year, which ends June 30, the total BAB subsidy the Treasury is expected to pay to California is $367.4 million, according to officials in that state. Of that amount, the state has already received $183.7 million. The outstanding balance owed by the federal government is $183.6 million and that amount could potentially be affected by sequestration.
“We prefer that the federal government honor its commitment under the BABs program,” said Tom Dresslar, spokesperson for California state treasurer Bill Lockyer. “That said, the loss of the subsidy is not exactly going to break the bank budget-wise.”
If California had to make up the difference for a subsidy payment reduction, it would come from the state’s general fund revenues, which are expected to increase by 7.7% in fiscal 2013, totaling $95.4 billion.
Similarly, California’s Bay Area Toll Authority, which is the sixth largest BAB issuer with $3.27 billion, isn’t particularly alarmed by the looming sequestration cuts.
Randy Rentschler, spokesperson for BATA, said the authority has $1 billion in its reserve fund. Because its financial situation is extremely strong, even in the worst case scenario of steep BAB subsidy cuts, “it’s not a significant issue for us with respect to our cash flow,” he said.
Several other large BAB issuers, including the Texas Transportation Commission and New York City, said they expect to cover their BAB debt service despite the payment cuts.
“For each of our BAB deals there are ample revenues to cover the debt service payments, even with a reduced BAB payment,” said Scott Sieber, spokesperson with New York City Comptroller John Liu. “Sequestration will have absolutely no effect on payments to New York City’s BAB bondholders.”
“However, we strongly feel that promised BAB subsidies are not an appropriate vehicle for federal budget balancing,” he added.
One consequence from a reduced BAB subsidy payment is that issuers will likely see an increase in their costs because the bonds’ credit is included in the sequester, Peter Orszag, former director of the OMB, said in a recent commentary for Bloomberg News.
Tax experts said Congress could take action to exempt BABs from sequestration and some are surprised they haven’t already done this.
The Budget Control Act of 2011, which was created in response to the failure of the congressional “Super Committee” to agree to a bipartisan deficit reduction package, exempts 155 accounts and programs out of a total of 1,200 accounts from sequestration.
Richard Kogan, a senior fellow at the Center on Budget and Policy Priorities and former senior adviser at the OMB, said the BCA was largely based on legislation from the 1985 Gramm-Rudman law, a budget deficit reduction measure.
Kogan noted that the most recent update to the mechanics of sequestration was in 2009 at the same time when BABs were created. The Obama administration should have added BABs to an exemption list, he said.
“No one thought about it and therefore no special rule was written to explain how they would be impacted,” Kogan said. “They didn’t want to renegotiate law, but it left in place all of those little warts and this is one of them.”
But Orszag said Congress could still exempt BABs from sequestration. “The problem for Build America Bonds could be fixed in various ways, including by reclassifying them into one of the categories that are protected against sequestration,” Orszag wrote.