In response to Exceptionally Strange Bedfellows; More Cookies! Oh Boy! I received an email from a former municipal bond trader “FMBT” for one of the largest municipal bond issuers in the US stating many reasons why it’s vital to put an end to Build America Bonds (BABs)

From “FBMT” on Killing BABs

Hello Mish,

I have been an avid reader of your blog for over 3 years now, and was a municipal bond trader for over 5 years. I wanted to write to you today about the about the need to contact our representatives and block any extension of Build America Bonds. These bonds were sold to us as a “costless” way to help municipalities get financing. Well, there are two major problems with that logic:

1. They are extremely costly.

The logic suggested when BABs were first introduced was that the federal government would pay 35% of the coupon, and investors would be taxed 35% ordinary income so the subsidy would be a wash. In theory, this makes sense. However, in practice, the large majority of these bonds have been sold to tax-exempt and overseas investors, who pay no US taxes.

Many overseas investors view municipal debt as a diversifying asset class, but until BABs it was very difficult for them to gain exposure to the market. Articles have been written on Bloomberg and the Wall Street Journal about how BABs have opened up the municipal market to overseas investors, quoting many municipalities and brokerages who underwrote the debt so this is a point that cannot be argued against

Assuming that a majority of the investors are tax-exempt and taking the following facts into account:

a. Roughly $250 Billion of BABs have been created
b. Most of the BABs are long-dated obligations so the value of the bonds is mostly in the coupon, not the principal
c. The Federal Government provides 35% of the coupon
d. This program has cost US Taxpayers as much as $250*35%=$87.5 Billion over the past year-and-a half. IT IS NOT A WASH.

2. These Bonds are assumed to have an implicit guarantee in the Municipal Market.

BABs are the first time that the federal government was directly responsible for payments from a state or local government. Municipal market professionals will argue (and the letter of the law would suggest) that only the municipality is the only credit on the hook in the case of bankruptcy, not the federal government.

We have heard this before with the implicit guarantee of GSE debt. Fannie and Freddie will end up costing US taxpayers $100s of billions if not trillions.

The end game is the same for many municipalities. They are bankrupt, they are broke, and BABs is the first step towards federalizing that debt. How many municipal professionals sell these bonds to their overseas clients on the basis of “there is no way the federal government will not step in”? The moral hazard in these instruments is very high.

We must contact our representatives and tell them to kill any attempt to add BABs to the tax agreement. These instruments are dangerous, unnecessary, costly, and a threat to our system. This is an issue of utmost importance, and I’m glad you are one of the few who understands what is at risk.

Please phone, email or Fax your legislative representatives, especially your senators, and tell them to make sure to scrap Build America Bonds.

Here is a complete list of Email addresses, phone numbers, and Fax numbers for US Congress and Governors. Unfortunately, many senators use a form. It may be easier to call. First, click on their name and see if there is an email address.

In addition to emailing or calling your own representatives, Please email House Speaker Boehner Regarding BABs. That link will put in a subject line of “Stop the Build America Bond Program”

Here is a sample email. Please use your own words.

Dear Senator [Speaker, Rep]
Please vote NO for any extension of the Build America Bond program. The US government should NOT be backing, sponsoring, or guaranteeing state or municipal debt.

Build America Bond have already cost taxpayers $87.5 billion because the bonds have primarily been sold to tax-exempt and overseas investors who pay no US taxes.

The worst part however is the Federal guarantee.

We have gone down that road one time too many already. Taxpayers are already on the hook for hundreds of billions of dollars of Fannie Mae and Freddie Mac debt because of it.

We cannot afford to make the same mistake again. Please vote NO for any extension of Build America Bonds.

Your Name
Your City, State, Zip

Addendum:

Reader Justin asks…

Mish,

If $250B of BABs have been issued, and the federal goverment pays 35% of the coupon, then the actual nominal amount of money expended by the federal government would be $250B x average coupon x 0.35, not $250B x 0.35. This is a big difference.

If we say that the average coupon is 6%, then $250B x 0.06 x .35 = $5.25B

Now the municipalities issuing these bonds obviously have incurred the other 65% of the coupon, but clearly that isn’t $87.5B.

Am I wrong?

“FBMT” replies …

That’s the nominal value per year, but the present value of all future payments is roughly my calculation.

Another way of looking at it is that investors pay $100 at issuance, for a 30-year bond the prinicipal repayment in 30 years is worth $100/(1+.06)^30=$17 so investors are paying $100-$17=$83 for the future coupon payments so a more accurate calculation would be
$250B*.83*.35= $72.6 Billion, a slightly lower number, but I thought that might be a little too complex to show.

Mike “Mish” Shedlock
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