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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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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.

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