The municipal bond market is having a tough time today largely in part of looming rumors concerning the expiration of the Build America Bond or ‘BAB’ program. After all, this program was omitted from Obama’s tax deal with Republicans.
As a part of Obama’s Recovery and Reinvestment Act, BABs allow state and local governments to issue debt to fund basic infrastructure projects at a 35 percent discount on the bond’s interest costs, handing that bill to the federal government.
CNBC reports that the BAB program accounts for nearly 26 percent of today’s municipal bond market- with October being reported as the biggest month for the program, as issuers increasingly position themselves to reap the benefits of the program which is set to expire on the 1st of January next year.
What will happen when municipal bond issuers are not able to borrow more cheaply? Well, heaven forbid, they would be forced to pay market rates for debt. If they can’t afford these rates, then they’ll have to cut spending and re-gear their budgets to enter the credit market. The 2010 election results at the state level may indeed have changed things. With a sweeping conservative, Republican wave in state and local governments this past election (the GOP took over a dozen state legislatures), it is almost certain that such cuts will now be possible.
According to Blackrock’s December 2010 Municipal Bond Market Report entitled State of the States and Local Governments, “[State and local governments] have accelerated spending cuts to reduce operating deficits.” This incoming class at the state and local government level will only advance cost cutting and budget balancing. They are being mandated to do so by their constituents. Such a mandate may be just what will protect the American taxpayer from another Obama bailout. Congressman Frank Wolf (R-VA) has most recently called for an audit on the $5.2 billion Dulles Rail project, which is already looking like it’s over budget. Such oversight is exactly the attitude we can expect from the incoming class of elected officials at the state and local level.
Market analysts are realists. They understand the need for funding at the state and local level and most importantly recognize the risk of insolvency. It’s possible. What happens if issuers default? Some are considering that the federal government should bail them out. In this scenario, the federal government would sweep in and settle reckless debt that, out of all things, was required for states to carry out basic political functions. Well, it may come as a shock, but the American taxpayer is not interested in bailing anyone out! If states or municipalities default, they would have to restructure their finances or file for bankruptcy- case closed. The reality is, the BAB program perpetuates a dependency between federal and state/local governments that as a result, has created an implicit guarantee for future bailouts (a Fannie/Freddie monster).
It’s no surprise that our most fiscally irresponsible state and local governments are heavily exposed to BABs to fund basic operations. According to Thompson Reuters, the top issuer of BABs is the state of California at over $13 billion dollars, followed by New York City at a significantly lower $3.5 billion. In June of this year, according to the Wall Street Journal, the state of Illinois was at greater risk of default than Iraq. In large part, the BAB subsidy was able to keep the state afloat. Will these governments default without this program?
On CNBC’s Strategy Sessions, Jonathan Beinner, CIO and co-head of the Global Fixed Income and Liquidity Management team, Goldman Sachs Asset Management, predicted that there will not be a large number of municipal defaults. Let’s hope he’s right. Considering their initial QE2 estimates, Goldman has recently had a habit of taking politics as the crow flies.
BABs are unhealthy for America’s free market. It is unfair for the American taxpayer to subsidize state and local borrowing costs. Why should they be at the front of the line? The federal government is giving an unfair advantage to issuers of this irresponsible debt by using the American taxpayer to prop up negligent states and municipalities that are reckless and largely ineffective spenders. If we could repeat 1986 and allow Donald Trump to come in and rebuild public projects like Wollman Rink in three months, $750,000 below budget, we would be much better off, albeit the flashy gold lettering.
Though the fragility of circumstances will only intensify for issuers once BABs expire, we can all agree that there is too much debt creation at the government level.
BABs are another form of Obama Era bailouts that we must do without.
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