Public Finance Update - May 2010

The Internal Revenue Service (“IRS”) recently published Notice 2010-35, which addresses the new direct payment option for certain qualified tax credit bonds under the Hiring Incentives to Restore Employment Act (“HIRE Act”).  The notice provides guidance with respect to, among other things, payment procedures for the direct payment option, as well as information regarding required elections and information reporting.

The American Recovery and Reinvestment Act of 2009 (“ARRA”) permits state and local governments to issue special purpose tax credit bonds, including Qualified School Construction Bonds (“QSCBs”), Clean Renewable Energy Bonds (“CREBs”), Qualified Zone Academy Bonds (“QZABs”), and Qualified Energy Conservation Bonds (“QECBs”), which all include provisions for tax credits to be provided to investors in lieu of interest.  Earlier this year, President Obama signed the HIRE Act, a $17.6 billion jobs bill that, among other things, permits state and local governments to issue the foregoing tax credit bonds as direct payment bonds.  Issuers of QSCBs and QZABs will get payments up to the credit rates that would apply if the bonds had been sold as tax credit bonds under ARRA.  Issuers of CREBs and QECBs will receive payments approximately equal to 70% of interest costs.

The new direct payment mechanism is similar to the successful direct payment structure of Build America Bonds.  Many in the municipal bond industry are hoping that these HIRE Act changes will jump-start the market for QSCBs, QZABs, CREBs, and QECBs, which have to date not drawn much investor interest.

Notice 2010-35 provides guidance with respect to various aspects of the new direct payment bonds, including:

• The issuer of direct payment bonds must make an irrevocable election to issue the bonds.
• Form 8038-TC (the IRS form required upon closing of the bonds) must be filed with the IRS at least 30 days before the first Form 8038-CP is filed to request the refundable credit payment for an interest payment date for the subject issue.
• For purposes of determining the refundable credit payments on a direct payment bond, original issue discount is not treated as a payment of interest.
• Direct payment bonds issued to reimburse otherwise eligible expenditures that were paid or incurred after the date of enactment of the HIRE Act and that were financed originally with temporary short-term financing issued after the date of enactment of the HIRE Act will not be treated as a refunding issue.
• Proceeds from direct payment bonds may be used to reimburse otherwise eligible expenditures, regardless of whether such expenditures were paid or incurred before or after the date of enactment of the HIRE Act.

The effective date of Notice 2010-35 was April 26, 2010. The notice applies to bonds issued after March 18, 2010.

Governor Arnold Schwarzenegger recently delivered his May budget proposal to the California Legislature in which he projects a $17.9 billion budget deficit for fiscal 2010-11.  In his proposal, the Governor refrains from recommending any new taxes, but suggests eliminating several major social welfare programs to remedy the coming shortfall.

The following table details the various cuts that the Governor has suggested in his May proposal:

Governor’s May Budget Proposal
Proposed General Fund Cuts 

Expense To Be Cut	Expected Savings
Reduce Proposition 98 spending (including elimination of child care)	$4,300,000,000
Reduce State employee pay and staffing, and shift pension costs to employees	2,100,000,000
Eliminate CalWORKs program	1,200,000,000
Implement various changes to Medi-Cal	900,000,000
Reduce inmate medical care costs	800,000,000
Reduce IHSS spending (excluding enhanced federal match)	800,000,000
Reduce county mental health realignment funds by 60%	600,000,000
Redirect county savings from social services reductions	400,000,000
Commit certain offenders to county jails, not state prisons	200,000,000
Suspend or defer certain mandate reimbursements(1)	200,000,000
Reduce spending in various health programs	200,000,000
Reduce spending in various social services programs	200,000,000
Reduce SSI/SSP grants for individuals to the federal minimum	100,000,000
Reduce other spending	300,000,000
Total	$12,300,000,000 (2)

____________________

^{1  _{Does not include $131 million for the proposed suspension of the AB 3632 mental health mandate.}
2  _{Remainder of deficit to be paid from revenue adjustments, including loans, sale of State assets, and expected federal funding.
Source:  California Legislative Analyst’s Office.}}

The California Legislative Analyst’s Office (“LAO”) recently released an overview of the Governor’s May budget proposal concluding that, while the deficit figures contained in the proposal are substantially accurate, the recommended budget cuts are ill-advised, especially the elimination of CalWORKs and child care funding.  In its report, the LAO recommends several revenue generating strategies, including fee increases, changes in tax expenditure programs, and delays in previously scheduled tax reductions or expirations, which it believes will lessen the need for the severest cuts suggested in the Governor’s proposal.

 The Governor’s proposal has been delivered to the California Legislature for consideration.  Senate and Assembly leaders are expected to meet with the Governor in June or July 2010 to work toward a compromise.  The California Constitution requires a two-thirds vote of the State Legislature to approve a budget.

In 2009, the California Legislature enacted AB 26 4x, which requires a shift of $2.05 billion of redevelopment funds from redevelopment agencies to county Supplemental Educational Revenue Augmentation Funds (“SERAF”).  The Legislature imposed the shift to combat the State’s budget troubles by reducing the amount of Proposition 98 moneys required from the State for local schools.

Redevelopment advocates, led by the California Redevelopment Association (“CRA”), filed a lawsuit seeking to overturn AB 26 4x, labeling the funds reallocation unconstitutional.  A Sacramento Superior Court upheld the constitutionality of AB 26 4x, but the decision has been appealed.

The California Court of Appeal recently denied a request by the CRA to issue a stay with respect to the shift of redevelopment funds.  Consequently, redevelopment agencies were required to transfer $1.7 billion of fiscal year 2009-10 redevelopment funds to SERAF on May 10, 2010, and, if the appeal proves unsuccessful, will be required to transfer an additional $350 million of fiscal year 2010-11 funds to SERAF next year.

The U.S. Department of Transportation (“USDOT”) recently announced its new “TIGER II” competitive grant program, a $600 million successor to the popular $1.5 billion TIGER program included in the American Recovery and Reinvestment Act of 2009 (“ARRA”).  TIGER II funds must be awarded by September 30, 2012, but there is no deadline for expenditure or project completion, which, unlike the original TIGER program, opens the door to projects not necessarily “shovel ready.”  When assessing candidate projects, however, TIGER II will still look for safety, economic competitiveness, livability, sustainability, and state of good repair (the extent to which a project improves the condition of existing infrastructure and minimizes life-cycle costs).  In addition, the TIGER II program will give special priority to multi-modal projects that incorporate new technologies or innovative approaches to finance, contracting, project delivery, congestion management, safety, asset management, and long-term operations and maintenance.

Under TIGER II, up to $150 million will be available for projects financed under the Transportation Infrastructure Finance and Innovation Act (“TIFIA”).  Under the original TIGER program, applicants could submit a letter of interest for TIFIA consideration with their TIGER grant application.  Under TIGER II, however, USDOT can award TIFIA assistance to applicants whether or not they request it – even if USDOT denies the underlying TIGER II grant request.  Only $60 million of an authorized $200 million was allocated to TIFIA under the original TIGER program.  USDOT’s new authority under TIGER II to award TIFIA assistance in lieu of, or in addition to, grant funding is expected to stimulate greater utilization of the TIFIA program.

TIGER II includes several additional aspects of note:

• Amounts Restrictions:  TIGER II grants must be for at least $10 million and cannot exceed $200 million.  No state can receive more than 25% of the funds.
• Federal Share Capped at 80%:  For most projects, the federal share will be limited to 80%, requiring a 20% local match.  This requirement was waived under the original TIGER program.
• Rural Projects:  In a significant shift from the original program, TIGER II requires the investment of at least $140 million in rural projects, which are exempt from the 20% local match and the minimum grant size described above.  Grants for rural projects must be at least $1 million.
• Planning Grants and USDOT-HUD Coordination:  TIGER II can provide up to $35 million in planning grants for activities related to the planning, preparation, or design of certain eligible projects, including transportation corridors or regional transportation systems.  USDOT intends to coordinate implementation of these planning grants with HUD’s $40 million Community Planning Challenge Grant program.  As with TIFIA funding, under TIGER II, USDOT can provide planning grants even if the applicant does not request such a grant and even if the applicant’s TIGER II grant request is denied.

Pre-application forms will be available on June 15, 2010 at: http://www.dot.gov/recovery/ost/TIGERII. Pre-applications are due by 5 pm EDT on July 16, 2010.  Applications are due by 5 pm EDT on August 23, 2010 and must be submitted through www.grants.gov. Applicants must be registered with the site, a process that takes two to four weeks.  USDOT will announce recipients on or after September 15, 2010.

The May 2010 yield on AAA-rated municipal bonds stayed relatively level for 30-year bonds at 4.39% and decreased slightly for 10-year bonds from 3.22% to 3.07%.  Yields on 30-year treasuries have fallen more sharply, however, dipping below munis for the first time since last December.



^{_{Source: Bloomberg (www.bloomberg.com)}}