CHICAGO – Illinois governments could lose up to $400 million in federal interest rate subsidies for Build America Bonds under prolonged federal budget sequestration.
That's according to a recently published study from the University of Illinois Institute of Government and Public Affairs, "The Feds giveth and the Feds taketh away."
The current tally on subsidy revenue lost to sequestration is $70 million for BABs issued by Illinois-based governments in 2009 and 2010 under the Build America Bond program established in the 2009 federal stimulus program.
The program allowed municipal issuers to issue taxable debt and receive a federal subsidy for interest payments, as opposed to issuing bonds with interest that is tax-exempt.
A total of $11.2 billion of BABs were sold in 245 issues in Illinois, according to the U.S. Treasury. Federal sequestration began in 2013, scaling back the 35% subsidy on interest rate payments.
"This is just another financial challenge that Illinois governments have had to manage over the past few years and will have to manage in the years going forward," wrote author Martin Luby, a professor at the University of Illinois institute and at the University of Texas at Austin. "The real concern is this is going to cost much more in the future if the sequester continues.
"Some governments will be able to manage this loss better than others," Luby added. "The loss in subsidies will pose a greater challenge for governments with weaker financial health."
Some Illinois local governments and sectors like higher education are already struggling with delayed or stalled state funding due to the state's prolonged budget impasse. Many also are strained by rising pension obligations so the reduced subsidies only add to their strains.
The analysis looked at the impact on 30 bond issues finding that federal reductions in BAB subsidies on interest payments due from March 1, 2013 through Jan. 1, 2017 totaled $53.9 million. The state government took the hardest hit of $18 million followed by Chicago which lost out on $10 million, according to an analysis.
The 30 issues accounted for about 78% of total statewide BAB issuance.
When applying the methodology used on the 30 to all Illinois government BAB issues, the lost revenue between 2013 and January rises to $69.3 million, the report said.
If the federal sequester stays in place through the final maturity of Chicago's BABs, subsidy reductions are estimated to rise from $10 million to $56 million, according to the report.
Based on the city of Chicago's losses, the total reduction in bond subsidies for all BAB issuing governments in Illinois through the final maturity of the bonds are estimated to be $394 million assuming the sequester remains, according to the report.
The BAB program was created to improve market access following the 2007 and 2008 credit crunch and financial crisis. The goal was to attract a new pool of buyers interested in taxable debt or unable to take advantage of the tax-exemption on traditional municipal debt.
More than $180 billion of BABs were sold nationally.
Since sequestration began, the federal government has reduced bond subsidies between 6.8% and 8.7% per year.
Some governments shied away from the program over concerns that the federal government could alter the subsidies in an effort to deal with its own fiscal budget issues, which is exactly what happened, resulting in sequestration.
That could fuel local governments' skepticism of any future programs modeled after BABs to help fund President Trump's calls for a $1 trillion infrastructure renewal plan, so any new programs need protections in place to shield against post-issuance cuts, the report recommends.
"Many public and private actors are reluctant to make decisions based on government policies that may be altered by future political leaders," Luby said. "Government policies must, of course, adapt to conditions and changing political ideologies but abrupt and unexpected changes can have significant costs and can undercut government credibility with respect to future policies."
Any new direct subsidy bond program should include provisions that protect it from budget sequesters; governments should consider funding a reserve fund with direct subsidy bond proceeds to provide a cushion to make up any federal subsidy deficiencies; and governments should consider selling direct subsidy bonds with more flexible early redemption provisions.
Initial BABs most often carried make-whole call provisions which are common in the taxable market and cut into the saving potential of refundings. As the BAB market grew, the cost of using traditional municipal 10-year par call features eased and some issuers gravitated toward the traditional call for the flexibility it afforded on future refundings.