WASHINGTON — President Obama’s draft debt-reduction bill, if enacted, could destroy the tax-exempt bond market because of the uncertainty it would create about the value of tax-exempt interest for investors, said market participants, most of whom were aghast that the administration would even float such a plan.

Currently circulating among lobbyists and members of the congressional deficit reduction committee, Obama’s 284-page draft Debt Reduction Act of 2011 would require the Office of Management and Budget to set ratios for debt as a percentage of gross domestic product beginning with fiscal 2013.

The ratios would decline 0.2 percentage points every year. If, in any given year, debt rose and the ratio was not met, automatic spending cuts in spending and tax preferences, such as tax-exempt interest, would be triggered for the next year. The process would be repeated each year.

“I think it’s a nightmare. You would effectively destroy the market,” said Christopher Mier, managing director of the analytical services group at Loop Capital Markets. “An investor can’t buy any investment with that level of uncertainty. I don’t think the market could function with that kind of a law.”

“Who wants to be captive to Congress? It’s just fundamentally unfair,” he said.

“The challenge is, for people who already own munis, this is causing a climate of uncertainty and some are thinking, 'Maybe the best thing I should do is sell,’ ” said John Hallacy, managing director and director of market research for Bank of America Merrill Lynch. “I think it’s harmful to the market to have some of these wild card variables out there.”

“This is another kick in the teeth from the Obama administration,” said Matt Fabian, a managing director at Municipal Market Advisors.

Issuers and representatives of issuer groups were particularly upset.

“This further demonstrates a disconnection between the policy perspective of Washington, D.C., and the true needs of state and local governments,” said Toby Rittner, president and chief executive of the Council of Development Finance Agencies. “In a time when our communities desperately need resources, the administration is proposing a solution that only threatens their ability to invest in the economy.”

“The president’s proposal complicates the municipal bond market beyond comprehension and triggers so much uncertainty that no investor, regardless of their relative income status, would be willing to invest in these bonds,” Rittner said. “We believe that this measure, if enacted, would put an end to the municipal market as we know it and would place the burden of increased cost of capital on state and local governments.”

“This is essentially a proposal to end tax-exempt bonds,” said Chuck Samuels, a member of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, who represents the National Association of Health and Higher Education Facilities Authorities. Samuels said it’s ironic that administration officials floated this kind of proposal, after assuring issuers of Build America Bonds that Congress and the federal government would never change the ground rules for the bonds after they were issued.

“Frankly, it also demonstrates again why — despite their clear attractions — many question whether state and local governments and nonprofits could ever count on appropriate federal support for direct-pay bonds,” he said.

Lars Etzkorn, program director for the National League of Cities’ Center for Federal Relations, said: “We’re certainly concerned by any suggestion that [the benefit of] tax-exempt [interest] should be curtailed or even eliminated, and this is the second recent expression from the White House that this might be good policy.”

“We think it’s counterintuitive,” he said. “Three-quarters of the infrastructure in this country is built and maintained by 50,000 state and local governments and authorities that issue tax-exempt debt. In this down economy, these are the entities creating jobs and this is not the time to fundamentally alter public finance.”

George Friedlander, a muni analyst with Citi, echoed that sentiment. “What remains disappointing is the apparent willingness of members of the administration’s team to severely reduce state and local governments’ capacity to finance its capital needs in order to achieve deficit reduction at the federal level,” he said.

“The threat to state and local governments in the overall deficit-reduction process is now clearly greater than ever than might have been expected, because at least some lawmakers are clearly willing to cut federal deficits on the heads of state and local governments,” Friedlander said.

Richard Ciccarone, managing director and chief research officer for McDonnell Investment Management, agreed. “They’re going to balance the budget on the backs of the state and local governments. The question is, could this bring the value of tax-exempt interest down to zero, if it were enacted?” he said, adding that issuers’ borrowing costs could skyrocket.

“The market would tend to price closer to that maximum discount risk and we would therefore see municipal obligations with borrowing rates that would go north of 50 basis points — higher than we’re currently seeing on triple-A munis,” Ciccarone said. “The more illiquid, the more lower-rated munis could see borrowing costs go to 150 basis points above than similarly rated munis.”

Fabian agreed there would be a major impact to the muni market. “In effect, upper-income bondholders would be dependent on Congress ensuring that their bonds remain exempt every year. As an investor, you would therefore need to expect your bonds would be fully taxable, pricing new purchases as if they were taxable already. Munis would thus need to be priced at a discount to fully taxable (but more liquid) corporate debt,” he said. “With capital costs much higher, in particular for small issuers, infrastructure financing would slow dramatically and possibly stop altogether for smaller, risky-sector issuers.”

But Fabian said the draft bill “would appear to be a non-starter: It would be a disaster for tax planning for homeowners, charitable givers, state and local taxpayers, not to mention muni bondholders.”

Samuels agreed, saying: “I think that, for a variety of political and substantive reasons, this particular proposal has little chance of passage. But it is incumbent on the muni community to ensure that outcome.”

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