On March 11, a new report on New York City's infrastructure needs noted that "Con Edison and National Grid each manage one of the oldest gas-distribution networks in the country." The very next day, a gas leak on Park Avenue in Harlem led to an explosion that killed eight people and wounded dozens more.
Aging, crumbling infrastructure is not just a New York problem, it is a national one. While disasters like the one in Harlem grab headlines, infrastructure deterioration more frequently has less devastating but still significant costs.
At the national level, the American Society of Civil Engineers reports that without more infrastructure investment, transportation delays, blackouts, brownouts and water main breaks will lead to increased costs of $1.2 trillion to businesses and $611 billion to households by 2020. The March report issued by the Center for an Urban Future estimates that New York City alone needs to invest $47 billion over the next five years just to bring infrastructure into a state of good repair.
Deteriorating conditions will cost American families an average of $3,100 per year in disposable personal income. And without action, we will suffer not just service outages or interruptions, but real tragedies related to our neglect in maintaining our public systems and infrastructure. While the need is massive and urgent, traditional infrastructure builders — state and local governments — postponed capital projects since the Great Recession, prioritizing instead the recovery of their balance sheets.
Searching for a pathway out of this malaise? The reintroduction of the Build America Bond (BAB) program would represent a step in the right direction. BABs are taxable state and local government debt for which a portion of the interest costs are subsidized by the federal government.
They were part of the federal stimulus crafted to address the sharp decline in economic activity and the extreme tightening of the credit markets that resulted from the financial crisis of 2008. BABs appear to be a proven and obvious solution to help spur much-needed infrastructure spending.
Buyer and Issuer Beware
The tax-exempt bond market exists to fund exactly the kind of capital improvements and repairs that are aimed at avoiding disasters like the one in Harlem. Yet the pace of issuance remains low, driven by issuers that have remained fiscally cautious since the recession.
While their fiscal caution is understandable, since 2009 the United States has dropped from seventh to 15th in the infrastructure category of the Global Competitiveness Report rankings. Meanwhile, total issuance in 2014 is forecast at $265 billion, the lowest level since 2000. Impending regulatory changes will almost certainly shrink the buyer base and thereby weaken the municipal marketplace.
Also, tax-exempts are likely to face challenging regulatory changes in the near term. First, there is the threat of a cap on tax exemption at the 28% tax bracket, which would weaken the value of tax exemption. Second, the fallout from the Volcker Rule and Basel III disincentivize banks, which own 15% of total outstanding supply, from holding municipal bonds.
Given the multiple challenges facing the tax-exempt market, now is the time to reform the market, before new capital has to be raised and deployed. Build America Bonds appear to be a proven and obvious solution.
Time for a Proven Solution
During the financial crisis, retail investors had withdrawn from the municipal bond market and institutional dealers had deleveraged their balance sheets by liquidating inventory. State and local issuers had no market access and infrastructure projects were temporarily sidelined. By the fourth quarter of 2008, monthly issuance had declined 32% from pre-crisis levels and relative borrowing costs had risen 100% in comparison to U.S. Treasuries.
In April 2009, President Obama and Congress provided our municipal issuers with an alternative to the traditional tax-exempt market through the BAB program. With BABs, the federal government subsidizes 35% of the interest of the taxable state and local government bonds.
BABs proved successful. Issuance resumed with BABs totaling $181 billion from April 1, 2009, to Dec. 31, 2010. Newfound liquidity was provided through a new, broader group of muni buyers that included taxable investors such as pension funds and endowments, life insurance companies and taxable mutual funds.
Finally, tax-exempt bonds also benefitted from the resulting reduction of long-term tax-exempt issuance. Muni issuers saved an estimated $20 billion in borrowing costs, on a present-value basis, as compared to issuing traditional tax-exempt bonds. Prior to its expiration, the BAB program proved to be an innovative alternative, providing unique market access to state and local governments in a cost-effective manner.
Re-introducing the BAB program would once again drive much-needed infrastructure spending and broaden the buyer base to non-traditional taxable investors, while at the same time providing a complementary alternative to the currently challenged landscape of the traditional tax-exempt market.
Granted, some modifications to the original program might need to be addressed, such as the subsidy level, which some argue is too onerous on the federal government, and the risk of reduced subsidy payment in the event of sequestration. Nonetheless, the underlying intent of the program remains an invaluable tool to finance the capital expenditures that our deteriorating infrastructure system desperately needs. Bringing back the Build America Bond program would allow us to borrow from the past to invest in the future.
BAB Benefits: Doing the Math
The aging Tappan Zee Bridge, a critical component of the transportation network connecting greater New York, had long operated beyond its capacity. Last year, construction began on a replacement bridge that will span the Hudson River at one of its widest points.
The financing of the bridge project offers an excellent example of the potential benefits of re-introducing the Build America Bonds program. The new bridge is projected to cost $3.9 billion, funded by a $1.5 billion federal loan and $2.4 billion of municipal debt. By our calculations, using current-market levels, the issuer could save $260 million (present value) in interest expenses by issuing $2.4 billion in taxable BABs instead of traditional tax-exempts.
These savings represent 15% of the total interest expenses associated with a traditional tax-exempt borrowing. We have assumed 30-year level debt amortization with a 10-year par call for both taxable BABs and traditional tax-exempt bonds. Further, the Internal Revenue Service would save $140 million through the direct subsidy of BABs versus the loss of income associated with tax-exempt issuance.
These savings represent 20% of the total cost attributed to the loss of income associated with the indirect subsidy of tax-exempt bond issuance. We assume BABs would have a 28% federal subsidy, down from the original 35%.
We also assume, rather conservatively, that the investor is subject to a federal tax rate of 35% in calculating the loss of income — given the preferential treatment of the tax-exempt nature of the traditional municipal debt.
The combination of the savings for both the issuer and the federal government equals $400 million and creates a win-win situation for everyone.
