Build America Bonds Are Officially A California Subsidy

The Build America Bond program will be a topic of discussion today when Obama meets with Congressional Republicans. Like the Bush tax cuts the enabling legislation for BABS is set to expire in a month. I don’t think the BABs extension is going to meet with any opposition. While it is a side show to the tax issue; BABs is probably more important. If it isn’t extended there is going to be a blowout in the tax-exempt Muni market. Should that happen you can kiss off any hopes of extending the economic recovery. Failure to extend BABs would trigger a (new) fiscal crisis for California. That would quickly spread to a few other key states.

BABs are taxable securities that offer municipal/state issuers a 35% subsidy on interest costs. The subsidy was supposed to be revenue neutral at the federal level. The theory was that the average tax revenue would be close to the 35% paid out. It hasn’t worked like that. The BABs bonds paid a nice yield and were gobbled by investors whose tax rate was closer to zero than the 35%. So the cost falls on the taxpayers and adds to the deficit. So which states are lining up deals that are fleecing federal taxpayers? Mostly Dead Beats (excluding Texas).



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BABs creates a tax arbitrage at the expense of taxpayers and to the benefit of (largely tax exempt) investors. The subsidy works. It allows states to pay up in yield while at the same time achieve a net interest cost that that is acceptable. The WSJ  had this to say about a Cali BABs deal last week:

The BABs were said to have attracted twice as many bids as the amount on offer, even after the state increased the size of the deal by $525 million because of the strong investor demand.

This comment from the California Treasurer’s spokesman says it all:

“California’s struggling? Hardly. We’re not struggling. We’re succeeding. We’re doing a job that’s vital to California’s fiscal and economic health, and doing it at the best possible price for taxpayers.”

If you were a taxpayer in Cali this statement would probably be accurate. But federal taxpayers are being bled to death in support of Cali.

How important is the BABs program to the stability of municipal finances in America? What might happen should Washington fail to pass an extension that keeps the window open a bit longer? Consider this comment from the Bond Buyer:

If the Build America Bond program expires at the end of this year, long-term tax-exempt bonds could lose their latest pillar of support.

I agree, except I would be more blunt. If BABs is not extended the Muni market will get smoked. The epicentre of the fire will be California, followed very quickly by New York. Knowing that, D.C. is going to kick BABs down the road. If they don’t, about $3 trillion in stimulus money spent over the past few years will have been wasted. If Cali/NY tank,  all the lights go out. We are much more economically fragile than we lead ourselves to believe.

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