Obama proposal for new bond program raises alarms over tax exemption

U.S. President Barack Obama speaks against automatic budget cuts scheduled to take effect next week, while in the South Court Auditorium in the Eisenhower Executive Office Building in the White House complex in Washington February 19, 2013.

Credit: Reuters/Larry Downing

The new bonds would be called America Fast Forward and be modeled after a popular state and local financing program from the 2009 economic stimulus plan, the taxable Build America Bonds (BABs), according to the White House.

For nearly two years, Build America Bonds caught on like wildfire. Issuers eager to take advantage of the federal rebates that were equal to 35 percent of the interest paid on the bonds sold $181 billion BABs over the 20 months of the program's existence.

"To the extent that his proposal...gives us another tool in our tool box, we are for it. We would welcome it," said Virginia Treasurer Manju Ganeriwala, who is also president of the National Association of State Treasurers.

But she added, "I'm cautious. It does worry me. I'm hopeful this is another tool, in addition to what we have."

For most of his time in office, Obama has suggested a reduction of the tax breaks on the municipal bond market. In particular he suggested capping the value of the tax exemptions for interest paid by municipal bonds . As the country reached the "fiscal cliff" at the end of 2012, the idea of capping the exemption gained in popularity among lawmakers seeking to raise revenues.

The $3.7 trillion municipal bond market provides a vital source of funding to local governments. Cities, states and local governments who sell tax-exempt bonds have stood shoulder to shoulder with investors in a fight to maintain the exemption.

They say limits to the exemption drive up borrowing costs for places already financially struggling and break promises to bond buyers.

As the federal government is seeking ways to cut its spending, issuers are skeptical about Obama's intent in the Fast Forward bonds. According to some estimates, the tax-exemption cost the Treasury around $140 billion a year.

The BABs program "made up only a small portion of the total number of municipal bonds that were issued to support infrastructure development and repair. Build America Bonds was, and remains, no substitute for municipal bonds," said Clarence Anthony, executive director of the National League of Cities, in a statement issued hours after Obama released his proposal.

The broad intent of the new plan is murky and so are many of the details. The plan by Obama did not give a rebate amount for the bonds and did not say if the rebates would be sheltered in federal budget cutting.

Last year, issuers were shocked to learn their federal BABs payments are subject to sequestration, the automatic spending cuts slated to begin on March 1. If sequestration takes effect there will be a 7.6 percent reduction in the subsidies paid to issuers of the bonds.

Since the BABs program ended in December 2010, Obama has suggested bringing it back in his annual budget proposals and members of Congress have drafted legislation reviving it. All proposals have included lowering the rebates issuers receive.

William Daly, head of governmental affairs for the National Association of Bond Lawyers, pointed out the Republican-dominated House of Representatives could like Obama's suggestion to include private-activity bonds in the Fast Forward program. Those bonds are issued for projects outside of typical civic works, such as building a stadium, and the inclusion would be considered " business friendly."

The Democratic-led Senate will take up Obama's proposal when it will consider a global tax reform, according to a staff member.

Municipal analysts at Morgan Stanley Smith Barney said in a note on Friday "the newly proposed legislation will encounter resistance in the House."

Meanwhile, Barclays municipal analysts said in a research note that "the probability of achieving large-scale tax reform has diminished greatly."

That would mean that the threat to the interest exemption is weaker, but "along the same vein, we believe the likelihood of a new BAB program is very low, given Republican opposition."

(Reporting by Lisa Lambert; Editing by Tiziana Barghini and Lisa Shumaker)