Public Finance Update - October 2011

President Obama recently delivered a draft of his Plan for Economic Growth and Deficit Reduction (the “Debt Reduction Plan”) to Congress. The Debt Reduction Plan provides for a steady reduction of the nation’s outstanding debt as a percentage of gross domestic product. If certain targeted ratios are not met in a given fiscal year, however, the Debt Reduction Plan provides for automatic cuts in spending and tax preferences – cuts that could adversely affect the tax exemption with respect to municipal bonds.

Another plan recently introduced by the President in the form of the $447 billion American Jobs Act of 2011 (the “Jobs Act”) also contained provisions that threatened the tax exemption on municipal bonds.  The U.S. Senate recently defeated the Jobs Act by a vote of 50 to 49 (60 votes were needed for cloture). If adopted, the Jobs Act would have capped the amount of tax-exempt interest, and other related expenditures and deductions, to 28% for all individuals earning $200,000 or more and for married couples earning $250,000 or more. The White House has indicated that the President intends to split up the Jobs Act into smaller pieces for resubmission.

The one-two punch of the Jobs Act and the Debt Reduction Plan has shaken the municipal bond market. At the National Association of Bond Lawyers’ Bond Attorneys’ Workshop, recently held in San Antonio, Texas, industry concern was expressed in a panel called “Tax Reform Update.”  Panelists agreed that the already suffering municipal bond market could be irreparably damaged by continued attacks on the exclusion of bond interest from gross income – the foundation of the market.

The Internal Revenue Service recently issued a private letter ruling to the State of California that permits the State to remarket $132 million of taxable Build America Bonds (“BABs”) issued in 2009 and 2010.  California is the first state to remarket outstanding BABs since the legal authorization for BABs expired at the end of 2010.

BABs represent one of the more successful programs authorized under the American Recovery and Reinvestment Act of 2009.  Under the program, the federal government generally pays a direct subsidy of 35% of the interest costs to a bond issuer, thereby lowering the borrowing cost for state and local infrastructure financing.  Over $180 billion in BABs were issued during the two-year life of the program. Many politicians, including President Obama, have proposed reinstating the BABs program.

At least three different groups recently have filed lawsuits challenging various aspects of the current California budget for fiscal year 2011-12. 

• The League of California Cities has filed a suit challenging the constitutionality of the State’s diversion of $130 million in vehicle license fees from cities and counties to pay certain State expenditures. 
• A group headed by United Cerebral Palsy of San Diego filed a suit claiming the State failed to follow proper procedure when it cut funding for certain programs that benefit the disabled.
• The California School Boards Association, the Association of California School Administrators, and several school districts filed a suit claiming the State violated its minimum funding commitment to K-12 education by more than $2 billion in the current budget.

These litigants join the ranks of the California Redevelopment Association and the League of California Cities; those groups previously filed a lawsuit challenging the constitutionality of the redevelopment bills ABX1 26 and ABX1 27 that accompanied the State’s 2011-12 budget package. The California Supreme Court has agreed to hear the case, and a decision is expected in January 2012.  Click here to read Goodwin Procter’s previous article regarding that case.

In October 2011, bond yields recovered slightly from their record lows in September.  Yields on 10-year paper rose from 1.71% to 2.47% on municipal bonds and from 1.90% to 2.13% on Treasury notes. Yields on 30-year securities rose from 3.51% to 3.69% on municipal bonds and from 2.98% to 3.13% on Treasuries.

Source: Bloomberg (www.bloomberg.com)