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Building America's Next Bailout

Here we go again.

Oct 11, 2010, Vol. 16, No. 04 • By CHRISTOPHER PAPAGIANIS
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It has become obvious in the past year that states face huge budget holes. And the federal government has come to their rescue: The $814 billion stimulus measure included over $280 billion to help states patch their budgets, and just before Congress went on its summer break, it scattered around another $26 billion to help with state health and education deficits. Despite these efforts, the cumulative budget shortfall for states next year is still projected to top $140 billion. Long-term, states also face massive shortfalls in pension benefits for public employees. They have promised over $3 trillion in retirement benefits and, according to the Pew Center, are at least $1 trillion short. How did states get into this mess? 

Building America's Next Bailout

Some were hit particularly hard by the recession, which crimped tax collections. Others simply made bad budget decisions, or put off necessary spending cuts for too long. But the federal government bears at least some of the blame by making it too easy for states to borrow money.

The main (and traditional) federal subsidy is allowing investors in bonds issued by states and localities to exclude interest payments from their taxable income. A second subsidy, much less well known, was created as part of the 2009 stimulus package: Build America Bonds, or BABs. The BABs program was an effort to reinvigorate the municipal bond market by giving states and localities a financing tool for capital projects that would be attractive to a new set of lenders—those who didn’t benefit from the traditional tax exemption.

Given the federal government’s history of subsidizing state and local borrowing, what’s wrong with a new financing tool? Put simply, it’s the name of the program, which was crafted well before the recent economic crisis, and how the bonds are being marketed abroad. These may sound like trivial objections, but the naming and marketing of these debt obligations is misleading and may introduce even greater volatility into municipal finance and the broader financial system.

Unlike traditional munis, the interest earned on BABs is taxable. This means that the states must pay higher rates of interest on them to attract lenders. The federal government in turn provides a cash subsidy to the issuing state or locality that equals 35 percent of the bond’s interest costs. From the state’s point of view, the cost of borrowing stays the same. But the BABs are especially popular with tax-exempt entities (i.e., pension funds) and foreign institutions that are not subject to U.S. income tax. These buyers or investors are generally unwilling to purchase standard municipal bonds because they do not benefit from the tax exemption.

Interest payments on bonds are included in investors’ ordinary income. Let’s say an investor with a 35 percent marginal tax rate contemplates buying some kind of bond. A corporate bond may yield 7.5 percent. Because a traditional municipal bond is tax-exempt, this investor would receive the same income from a municipal bond that yields 4.875 percent. (You can see how much money a state or local government saves by being able to borrow at a much lower rate.) Once investors bid the municipal bond’s yield down below 7.5 percent, however, it no longer makes sense for tax-exempt or foreign investors to buy the security. With a BAB on the other hand (to continue this same example), the investor would receive 7.5 percent while the state government, thanks to the federal subsidy, would still be borrowing, in effect, at 4.875 percent.

The BABs program has significantly increased foreign investment in the municipal debt market. (“Municipal debt,” for the uninitiated, is a catch-all term for all government borrowing below the federal level—by states, cities, localities, and their agencies.) According to the Treasury Department, there have been 1,543 separate Build America Bonds issuances in 49 states, totaling more than $122 billion since the program’s inception in April 2009. Many observers view this positively, as expanding access to credit means that states can borrow more now rather than enact painful budget cuts. But it’s only good news if no one defaults. And as of this spring, state and local governments already had $2.4 trillion of debt outstanding. It is worth noting that Build America Bonds have become the fastest-growing part of the municipal bond market. In 2010, BABs are on a path to account for between 20 and 30 percent of the entire municipal debt market. 

Net foreign purchases of municipal debt have increased nearly tenfold since the first BAB was issued. Federal Reserve data suggest that foreign buyers have acquired more than 40 percent of all BABs issued in 2010. Indeed, in a little more than a year, foreign investors have gone from financing virtually none of the municipal debt in this country to more than 70 percent of all new issues. By the end of the second quarter, the Fed estimates that foreigners held $83 billion of municipal debt, virtually all of it in BABs.

In July, Illinois went to market with a $900 million BAB issue that attracted 93 investors, including 17 from overseas. The international investors accounted for about 30 percent of the offering. Illinois state officials even joined their underwriters, Citigroup, on a road show through Europe and Asia to drum up interest in the sale. 

Unfortunately, the rising popularity of BABs could make a federal bailout of the states more likely, because there is now a new class of investors (foreigners) who can reasonably claim to have been misled as to who is ultimately responsible for these debt securities. As with regular municipal debt, BABs are not backed by the federal government. Yet these bonds have the “Build America” brand​—and not the moniker that would be more accurate: “Help deeply indebted states borrow more to build more stuff.”

Not surprisingly, confusion about who stands behind these obligations has contributed to the program’s popularity. The fact that cash-strapped California has issued 22 percent of all BABs since the program’s inception is one of the more troubling signs supporting the hypothesis that foreign investors view these securities as enjoying an “implied” federal guarantee.

International investors—and U.S. taxpayers—are all too familiar with implicit guarantees. Fannie Mae and Freddie Mac, the U.S. government-sponsored enterprises (GSEs), grew into behemoths that profited from their special relationship with the government—then left taxpayers holding the bag when things went south. To date, U.S. taxpayers have had to pay $150 billion to bail out Fannie and Freddie.

Foreign investors were also huge buyers of the debt obligations of the GSEs—and they were a big part of the U.S. government’s rationale for bailing out the GSEs. Before the implicit federal guarantee for the GSEs was made explicit—when the U.S. government literally took over Fannie and Freddie in 2008—China held more than $500 billion and Russia more than $100 billion of GSE debt obligations. In total, foreign investors owned more than $1.6 trillion. 

All of this foreign investment in Fannie and Freddie helped channel global liquidity to support U.S. home-ownership. Yet when it became clear that the enterprises’ assets could no longer support their liabilities, these same foreign investors began selling their debt obligations on an unsustainably large scale until the federal government agreed to step in. In his recent book, former Treasury secretary Hank Paulson mentioned that he received intelligence suggesting the Russians and Chinese discussed coordinating their efforts to put pressure on the U.S. government to act.

Sadly, the situation with Build America Bonds reveals that the U.S. government hasn’t learned its lesson. It looks like foreign investors are betting that if a state or locality starts to struggle with BABs payments, the federal government will step in with a bailout or guarantee—just as it was pressed into doing with Fannie and Freddie.

So here we go again. The first half of the story is the same as the GSE saga. Foreign investment in BABs is helping states avoid spending cuts in the near term and helping to advance new construction or building projects. But what’s going to happen when it becomes clear to investors that certain states and localities no longer can support all their liabilities? If these foreign investors begin selling BABs on a large scale, will the federal government refuse to step forward with a guarantee? Right now, it looks increasingly likely that the federal government will step into the breach. 

The Obama administration and Congress owe it to taxpayers to clarify​—now, before it’s too late—that “Build America” bonds are not backed by the federal government. If they don’t make this explicit, the total foreign holdings of BABs might be large enough to force Washington’s hand in the not-so-distant future. And while the BABs program is set to expire at the end of the year, there are several pieces of legislation pending before Congress that would extend it beyond this year.

As Congress considers these bills, now is the perfect time for the U.S. government to include legislative language clarifying who exactly stands behind Build America Bonds—namely, the state and local governments that issue them. If this situation isn’t addressed and the program is extended for several years, foreign holdings of municipal debt could easily exceed $150 billion. This is not a small number, even for a market that’s measured in the trillions. In fact, it’s roughly equal to the total foreign holdings of Greek government debt, which was enough to spark a debt crisis in Europe earlier this year.

A key lesson from the financial crisis is that creditors based expectations on informal relationships between entities instead of strictly defined legal relationships. What began with banks having to rescue structured investment vehicles and other “sponsored” off-balance sheet entities (that were not technically guaranteed) only ended when governments stepped in with a broad banking industry bailout. The lesson to lawmakers should be clear: Seemingly innocuous promotional material or coordinated efforts to expand investor interest can be viewed as implicit backing for the creditworthiness of the underlying obligations. 

Build America Bonds are also blunting the incentives for states to borrow less, which would be a logical response to their deteriorating credit profiles. Access to a new class of bond buyers, in short, has fueled more borrowing by state and local governments. It’s a slow-burning fire (for now) that could get out of hand and require federal intervention. 

Harrisburg, Penn., for example, announced on September 1 that it will skip a $3.29 million debt payment that is tied to a $288 million incinerator project that has roughly $68 million of debt outstanding. Days later, the governor and the state government had to step in to help the city out. Unfortunately, some big state governments around the country—California and Illinois in particular—are severely strained and it’s possible that some other cities and municipalities won’t be as fortunate as Harrisburg.

While the numbers from Harrisburg may not sound that large, this situation was on track to be the second-largest municipal default this year, and many market analysts worry that it could be one of the early signals of more defaults over the coming months.

Making marketing materials clear and perhaps capping—or even lowering—the federal subsidy would lead to less borrowing by less-creditworthy municipalities and more borrowing by more-creditworthy municipalities. In this way, the likelihood (and magnitude) of municipal bailouts would decrease. The federal government can protect taxpayers and avoid building America’s next bailout. It just needs to prevent the BABs program from expanding until it’s too big to fail.

Christopher Papagianis, managing director of e21, was previously special assistant for domestic policy to President George W. Bush.

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